A big door is opening for the regional capital market
Come Monday morning, 01 October, eleven South African government bonds enter the Citigroup World Government Bond Index. This is the first time ever that any government bond from any African country has been considered for inclusion in this benchmark index.
This news is not new. In April, it was officially announced that some South African government bonds are on review for inclusion in the index. During the review process, the SA capital market was rated for size, liquidity (credit) and barriers to entry. Bonds in the index are weighted, have to have maturities of one year or longer, and must exceed US$25 million in outstanding value. South Africa’s weight in the index will be approximately 0.44%. This weighting is comparable to other emerging market customers with Malaysia at 0.37%, Finland at 0.45%, Ireland at 0.51%, Poland at 0.55% and Mexico at 0.64%.
South Africa is now playing in the big league as far as emerging markets go. The Citigroup WBI consists of 22 countries (including South Africa) and other EM partners are conspicuous in their absence. Neither China, nor Russia or Brazil, has any government bonds listed there.
Inclusion in a bond index as influential as Citigroup’s holds major benefits, chief of which is an anticipated reduction in borrowing costs for the issuing sovereign. Membership of Citi’s index is rated significantly higher than the window-dressing BRICS membership as illustrated by the entry of Mexico, Poland and Malaysia when 10-year bond yields dipped between 100 and 200 basis points over the first few months.
Most fund investors are controlled by tight or very prescriptive mandates. When an index or, specifically, a bond fails to comply with the mandate requirements, the fund managers are forced to relinquish their positions and shift to another instrument that complies with mandate rules. What this means in practice is that, regardless of the attractiveness of any African bond, if it does not comply with mandate rules, it is simply not considered for inclusion in an asset portfolio. In the strictest sense, it would be illegal for certain fund managers to buy into a bond which falls short of stipulated criteria. A rating of BBB+ or higher, is one such criterion while inclusion in a recognised index, is another.
The earmarked SA bonds will remain exactly as they were before the inclusion. There are no changes to maturities, coupon value, or float. The only difference is in the way that they are now viewed and appraised by the international investment community. Inclusion in the index provides a type of semi-statutory acknowledgement that these bonds are tradeable liquid instruments in a market with sufficient liquidity and capacity to participate in the bond market at large.
Although it is somewhat premature to anticipate the impact of the inclusion on the bonds’ market value, it is generally expected that CWBI credentials lead to lower bond yields, thus lower borrowing costs for the owner of those bonds, in this case the South African government.
In their desperate search for yield, fund managers are disrupting markets worldwide. The observed volatility in all the world’s big markets, is the direct result of short-term investments rapidly flowing into, but just as rapidly leaving, certain asset classes. In this sense, a surge in international trading of SA bonds also has the potential to disrupt South Africa’s capital market, but it is not widely expected. The SA capital market is simply too big, diversified and sophisticated, to be upset by portfolio inflows and outflows. That is the reason why the listing criteria consider market size, as well as bond size. It is expected, however, that an influx in portfolio inflows will have an impact on the Rand exchange rate. It may just happen that the Rand trades again at around R7-80 before year end.
If I am correct in expecting an improvement in liquidity, it means SA bonds will become more popular. This should drive down yields. But SA bonds still yield far more than say, European, American or Japanese bonds, so the 8.8% current yield on the 20-year benchmark bond, is indeed very attractive. Compare this to the 3.58% yield on the JP Morgan Emerging Market Bond Index.
The index lists government bond for Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Malaysia, Mexico, the Netherlands, Portugal, Singapore, South Africa, Spain, Sweden, Switzerland, the United Kingdom, and the USA.