By: Thalia Petousis, Portfolio Manager at Allan Gray
The notion of a government bond trading at a 12% yield can sound very appealing, but it poses several issues. The first is for the bond investor. To own a government bond at a 12% yield does not mean one is earning 12% per annum. On the contrary, while the South African government 20-year bond has traded at an average yield of 12.1% this year, the total return for a holder of this bond over that period has in fact been marginally negative.
The reason for this is that while this bond started the year at 11.5%, it last traded at 13%. Put simply, one has been taking capital price knocks along the way, which eat away at one’s return as the bond’s market value is made cheaper. Another way to think about this, as put forward by South African Reserve Bank Governor Lesetja Kganyago at the September Monetary Policy Committee meeting, is that bond investors are essentially asking for more butter and jam to spread on the proverbial South African bread. The yields are rising.
A more serious issue, perhaps, is the fiscal implications of the South African government issuing debt at a 12% yield while nominal economic growth is climbing at around half of that, or 6%. In this situation, government’s interest expense grows and compounds at a much faster rate than tax revenue growth, requiring cost-cutting measures to offset growth in the unfunded interest bill. Using theoretical estimates, if nominal GDP grows at 6.5% per annum for the next seven years while government’s cost of interest remains at 12% or more, then even if we manage to run a neutral primary balance every year (i.e. government revenue equals government spending, ignoring the interest bill), by 2030 we could easily be in a situation where debt is close to 100% of GDP and where approximately 40 cents on every tax rand that is raised goes towards servicing interest on old debt.
The only way to neutralise the fiscal deterioration from such a growing debt burden is to embark on fiscal austerity and put aside large primary surpluses in the budget every year. A version of such an approach is currently being proposed by National Treasury and the Finance Minister, Enoch Godongwana, although with some resistance from government and unions. This is perhaps understandable when one questions the appropriateness of austerity in a country with such devastating levels of social poverty and unemployment. Treasury’s challenge will be to cut spending in areas where it is wasteful and keep the taps open where it is being routed to social welfare and critical infrastructure. Treasury argues for a restructuring of the public sector by closing redundant government departments and reducing the headcount, as well as scrapping a host of smaller spending programmes that are seen as non-critical.
These strong measures are being proposed as the market awakens to the realisation that the Budget estimates tabled in February were not credible. As discussed in previous pieces, the February Budget greatly overestimated corporate income tax collection, which has subsequently been decimated by a decline in commodity export prices and the severe cost of loadshedding, while also pencilling in far lower public sector wage increases than those ultimately agreed to with striking unions. Against this backdrop, we have already seen Treasury raise their weekly issuance of short-dated T-bills from R12.4bn per week to R14.8bn per week. Any move to raise the issuance of longer-dated government bonds will put further pressure on yields, which is a risk we are vigilant about.