By: Pako Thupayagale,Portfolio Manager, 4Factor & Malcolm Husselmann, Portfolio Manager, Emerging Market Fixed Income
Investment attributes that have endured over time
Investors have traditionally been guided by the investment objectives of safety, liquidity and return. The concept of safety has generally been interpreted to mean preservation of capital, such that, investments are undertaken in a manner that maintains the ‘purchasing power’ of a portfolio over the specified investment horizon. Safety within the context of fixed income assets, is also associated with the credit rating of the sovereign (or relevant issuer). Liquidity relates to the conversion of assets into cash, without undue sacrifice in value. More broadly, the ability to easily enter and exit investment positions is reflective of market liquidity. Lastly, without undermining safety and liquidity, a portfolio should be invested in a manner consistent with maximising return within a framework of acceptable risks.
From a portfolio construction perspective, these three attributes are often viewed as interdependent variables that are essential for executing an investment policy. It is, therefore, relevant to examine the bond markets of Namibia and Botswana within the context of this framework.
A snapshot of Botswana
With a history of recording budget and current account surpluses, the government of Botswana had no reason nor urgency to issue debt. However, Botswana’s strong capital market development focus led to the introduction of the Government Note Programme in 2003 with the twin aims of:
01. Establishing a reference yield curve (for other bond issuers)
02. Widening the range of investible securities
More recently though, it appeared that bond issuance could potentially be used as an alternative source of government funding in light of fiscal deficits experienced by the country in the aftermath of the Global Financial Crisis and the low level of public debt. However, a ‘pay-as-you-go’ mindset, and budget projections showing a move from an overall deficit to surplus over the next five years, as reflected in National Development Plan 11, suggest a continuation of the authorities’ measured approach to issuance. Against this background, excess demand for government securities characterises the market, which may explain why the local bond market appears to be rich from a valuation perspective (Figure 1).
Figure 1: Current vs. fair value yields
Source: Investec Asset Management estimates, as at 31.07.18.
After a period of respectable bond market returns, the outlook has become more challenging. Figure 2 shows that inflation-adjusted returns have been trending downward, suggesting the erosion of purchasing power and compromising the attainment of ‘safety’. The local debt market has the peculiarities of a private debt market. This is reflected in intermittent secondary market activity and a pervasive buy-and-hold investment strategy. While illiquidity represents a constraint to efficient portfolio realignment, this need not necessarily be a deal-breaker for long-term investors.
Moody’s and Standard & Poor’s have reaffirmed the ratings of A2 and ‘A-/A-2’, respectively for longand short-term bonds in domestic and foreign currency. This notwithstanding, the returns on government securities are losing attraction relative to comparator countries.
Figure 2: Bond returns across various horizons
Source: Investec Asset Management estimates, as at 31.07.18.
The government bond market in Botswana is increasingly challenged to satisfy the requirements of safety, liquidity and return. The present environment is marked by an accommodative monetary policy, a subdued inflation outlook and no great urgency for the government to issue bonds beyond its capital and debt market developmental objectives. This, in turn, suggests re-considering notions of safety, liquidity and return, for example, by specifying a clear income objective, subject to a risk budget and liquidity thresholds. The alternative is to look elsewhere (i.e., in other asset classes/markets) for safety, liquidity and returns since they don’t seem to be sufficient, given the current and prospective circumstances of the local government bond market.
What are the implications?
Since government bonds account for almost 70% of listed fixed income securities, their apparent overvaluation could compromise future returns and ultimately, the financial well-being of clients. Against this background, a greater openness to unconstrained fixed income strategies in Botswana could potentially help deliver safety, liquidity and return while also spurring the development of the local market. Unconstrained strategies can help limit interest rate risk by maintaining shorter durations than traditional benchmarks, which is an advantage if rates start to rise. These strategies offer the potential to generate excess returns through diversification and access to a broader opportunity set.
The view from Namibia
Following the Global Financial Crisis, the Namibian government pursued a very expansionary fiscal policy with a view to deepen and broaden economic growth. Ultimately, the aim was to meet its sustainable development objectives – especially in respect of economic progression and social transformation. The shift in the fiscal policy stance from conservatism (after 18 years of mostly balanced budgets) to a procyclical and transformative agenda was marked by a sharp deterioration in debt metrics. The debt-to-GDP ratio increased to 43% at the end of 2017 from 15% in 2009. Similarly, the current account (CA) experienced an unprecedented decline. By way of comparison, from 1990 to 2008 the CA averaged 3.9% of GDP, whereas for the period 2009 to 2017 it represented -6.3% of GDP (Figure 3.) This reversal in fortunes was driven by a credit boom, significant increases in investment, as well as elevated public spending.
Figure 3: Namibia debt-to-GDP and current account-to-GDP ratios
Source: Investec Asset Management, Bloomberg, IMF, as at 31.07.18.
Together, these ‘twin deficits’ have the potential to hamper the achievement of macroeconomic stability. The economy is in the grip of its worst recession since independence, with six of the last eight quarters recording a contraction in real GDP growth. In addition, international credit rating agencies, Moody’s and Fitch downgraded Namibia’s long-term foreign currency credit rating to sub-investment grade in 2017 (after 12 years as an investment grade issuer.)
Safety, liquidity and return in the context of Namibia
From June 2010 to June 2018, government debt swelled from N$9 billion to N$56 billion in the local bond market, a net increase in issuance of N$47 billion – or a rise of 523%. During this period, the economy also performed well, thanks largely to the implementation of a procyclical fiscal policy. Over the past eight years, the size of the overall economy increased in nominal terms by 132%, notwithstanding the slump over the past 18 months. Evidently, this growth was fuelled by fiscal expansion funded by an increase in government debt. Despite the growth in the economy, the debt burden has increased disproportionately. Debt servicing costs have escalated from 4.5% of government revenue in 2010 to a projected 11.5% of revenue in 2018.
The rapid pace and level of issuance on the part of government over the last eight years has crowded out the private sector in the bond market. Government debt currently accounts for 90% of the total debt in issuance on the Namibian Stock Exchange, versus 77% in June 2010. The rise in government borrowing has led to an overall increase in funding costs for the economy. Benchmark rates, reflected in the government bond yield curve, have gone up as capital providers demand a premium to compensate them for the perceived rising risks of lending to government. This can be seen in the spread the market has priced into the bond yield curve over the benchmark South African yield curve (see Figure 4).
Figure 4: Namibia vs. South Africa 10-year bond yield
Source: Investec Asset Management, Bloomberg, as at 31.07.2018.
Despite this glut of issuance, liquidity is still very limited in the Namibian bond market, with investors maintaining a buy-and-hold approach. For the first six months of 2018, less than 1% of total local government bonds in issuance traded on the exchange. New legislation, the Financial Institutions and Markets Bill, should help alleviate this illiquidity in the medium term. In the meantime, market illiquidity remains a constraint to Namibian bond investors, pending the implementation of reforms such as the establishment of a Central Securities Depository and the introduction of an electronic bond trading platform1.
Bond market returns have been good, despite rising risks associated with the sustainability of government finances. Over the last three and seven years, bond returns have delivered an average real return of 3% and 3.2%, respectively. Furthermore, the bond market is still attractively priced with the ten-year bond offering a real return of almost 5.2%. While inflation is projected to trend higher over the next three years, the expectation is that it will not breach the upper limit (6%) of the central bank’s inflation target.
Where to from here?
The safety of the local bond market has markedly decreased over the last three years with the Namibian government’s creditworthiness being scrutinised. However, the government has initiated small but key steps towards fiscal consolidation. From an investment perspective, we see value in diversifying away from government bonds into an array of local market credit opportunities to improve returns and decrease volatility. While liquidity has always been a challenge in the Namibian bond market, there are signs that this will improve in the medium term, considering various policy reforms and market practices, which should allow us to express our investment views more nimbly over time. Despite the safety and liquidity concerns, the current valuations in the local bond market offer value. Consequently, we are optimistic that this will translate into solid risk-adjusted return over the next three to five years.
We believe a framework rooted in safety, liquidity and returns has relevance to clients in both Namibia and Botswana. Furthermore, it provides a clear approach to generating performance and a transparent framework for clients to hold us accountable.
1It is important to note that the experience of Botswana shows these innovations are a necessary but not sufficient condition for greater liquidity.
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