The South African bond market:The South African bond market: A practitioner’s perspective of progress, A practitioner’s perspective of progress,

problems and prospectsproblems and prospects

Presentation to OECD seminar on “How to reduce debt costs Presentation to OECD seminar on “How to reduce debt costs

in Southern Africa” , Johannesburg, 25/26 March 2004in Southern Africa” , Johannesburg, 25/26 March 2004 Gordon Smith(+27 11) 775-7256gordon.smith@db.com Deutsche Bank AG

Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF THE BODY OF THIS RESEARCH

2 Structure of presentation Structure of presentation

Executive summary

Macro drivers and relative asset performance

Impact of fiscal policy on SA’s bond market

Maturity profile and yield spread dynamics

FX risk; benchmark and ownership issues

Some conclusions and suggestions

3 Executive summary Executive summary SA’s bond market reflects the economy in which it operates; notably

declining savings/low growth limit issuance capacity

Legacy effects still cause most asset allocation professionals to shun bonds even as their recent returns have trounced equities

Impressive fiscal reform has facilitated market consolidation, as apparent in growth in offshore sovereign/local corporate issues

Yet, rand volatility/sovereign credit considerations cap foreign issuance while strong cash-flows meet corporate funding needs

The ‘off-index’ EM benchmark status of local bonds has held back foreign participation in the market, in contrast to equities

A falling inflation premium/further sovereign credit re-rating should continue to sustain a hesitant unwind in real bond yields

4 Macro drivers and relative asset Macro drivers and relative asset performance performance SA bond market: Predictor of economy/policy

A very brief history of SA’s macroeconomics

SA yield dynamics and structural adjustment

SA bonds outperform equities and inflation

Legacy drag on institutional asset allocation

5 SA bond market: Predictor of SA bond market: Predictor of economy/policy economy/policy

Economic efficacy: Yield curve predicts IP (most cyclical, large component of GDP) by about a year. Current spread predicting sustained turnaround in IP cycle later this year.

Policy efficacy: Bond investors/SARB constantly keeping an eye on each other, with long rates usually leading short rates by six months, except during sudden “crisis” events.

source: I-Net Bridge; Deutsche Securities source: I-Net Bridge; Deutsche Securities

10Y less 3M benchmark

(led 12 mths,lhs)

IP (12MMA, % y-o-y, rhs)

7

9

11

13

15

17

19

21

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

10-year SAGB yield (%)

Base rate* (%)

*Pre-April 1998 Bank Rate; post-April 1998 Repo Rate

6 A very brief history of SA’s A very brief history of SA’s macroeconomics macroeconomics

Macro theory would posit transmission mechanism of falling savings => falling investment => rising real rates => lower growth. SA delivered a textbook response after 1980.

Open economy macro theory would posit need for rising real rates on abolition of dual currency regime in 1995, allowing current account deficit to be adequately funded

sourc

e:

I-N

et

Bri

dge;

Deuts

che S

ecu

riti

es Gross capital formation(% GDP, lhs)

Gross savings (% GDP, lhs)

5-year trailing real 10Y SAGB yield(%, rhs)

7 SA yield dynamics and structural SA yield dynamics and structural adjustment adjustment

Falling cyclicality has been primarily due to halving or more of sustainable inflation since onset of 1) real rate regime (from 1988) and 2) exchange control relaxation (from 1995)

Lagged response of yields to inflation evident in rising real yields, reflects bond investors’ vigilantism towards inflation risk and thus sustainable achievement of 3-6% CPIX target

source: I-Net Bridge; Deutsche Securities

Real GDP volatility (5-year trailing average, %)

source: I-Net Bridge; Deutsche Securities

CPI inflation

10-year SAGB yield

CPIX inflation

8 SA bonds outperform equities and SA bonds outperform equities and inflation inflation

With lower cyclical economic volatility, primarily due to sustained macro-level reforms, bonds have structurally outperformed equities since 1986, but markedly so since 1994

As a result, bonds have been a superior inflation hedge. While this is a dire verdict on risky asset returns in the last decade, it reflects the high costs of structural adjustment.

source: Deutsche Securities source: I-Net Bridge, Deutsche Securities

0.3

0.5

0.7

0.9

1.1

1.3

1.51

98

5

19

87

19

89

19

91

19

93

19

95

19

97

19

99

20

01

20

03

ALSI relative to ALBI Total Return Equity Bonds Inflation(Total return, %) (Total return, %) (CPI, %)

1986 56.5 35.9 181987 -4.7 14.8 14.71988 14.9 8.3 12.61989 55.5 21.5 15.31990 -5.1 16.2 14.61991 31.0 14 16.21992 -2.0 27.3 9.61993 54.7 31.5 9.51994 22.6 -9.3 9.91995 8.8 29.6 6.91996 9.3 6.3 9.41997 -4.5 28.7 6.11998 -10.0 4.8 91999 61.3 29.4 2.22000 -0.1 19.3 72001 29.1 17.8 4.62002 -8.2 16 12.42003 -0.9 14.8 0.3Compound ave return14.7 17.6 9.8

9 Legacy drag on institutional asset Legacy drag on institutional asset allocationallocation

SA fund managers have been mandated to relatively outperform, thus institutionalising a risk bias towards equities, which are also thought to have better inflation-hedge qualities

Where we have seen bond investors’ reticence to fully discount a sustained fall in inflation risk, it is no real surprise that this pro-equity asset allocation legacy continues to persist

sourc

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Ale

xander

Forb

es

0

10

20

30

40

50

60

70

80

3Q01 4Q01 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03

Equity Fixed income

Core Institutional asset allocation (%)

10 Impact of fiscal policy on SA’s bond Impact of fiscal policy on SA’s bond market market Steady not stellar growth in SA bond market

Some diversification in concentrated market

Fiscal conservatism drives sovereign rating

Shifting issuance bias in SA bond market

Cash-flows funding private capital intensity

11 Steady not stellar growth in SA bond Steady not stellar growth in SA bond market market

Bond capital raising will be a function of the economy’s savings constraint; as we have seen, SA’s reforms have helped to dampen GDP risk but not yet revive trend growth

In US$ (numeraire) terms, while SA’s bond market is barely changed from a generation ago, it remains comparable, in (US$) GDP terms, to Russia, China and South Korea

source: I-Net Bridge; SARB source: Deutsche Securities

0

50

100

150

200

250

300

350

400

4501

98

6

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

0

10

20

30

40

50

60

70

80

90

100

Public sector bond market cap (ZARbn, lhs)

Public sector bond market cap (US$bn, rhs)

0

20

40

60

80

100

120

140

160

Mexic

o

Ru

ssia

Ch

ina

Sou

th A

fric

a

Sou

th K

ore

a

Pola

nd

Mala

ysi

a

Bra

zil

Th

aila

nd

Ind

ia

Ind

on

esi

a

Ph

ilip

pin

es

Tu

rkey

Arg

en

tin

a

External debt/GDP (%)

Domestic debt/GDP (%)

12

In their SA bond market exposure, investors face:

Less domestic sovereign dominance with growth in foreign and corporate issues

Concentrated liquidity in benchmark issues; SAGB, parastatal and corporate

source: BESA; SARB

Some diversification in concentrated Some diversification in concentrated market market

SA Government Bonds64%

Sub-sovereign10%

Corporate

13%

SA Foreign debt13%

ZAR352bn

ZAR74bn

ZAR71bn

ZAR54bn

source: SA National Treasury

Turnover ratio*2002 2003

R150 (2004/05/06) 61.2 48.3

R194 (2007/08/09) 21.5 26.7

R153 (2009/10/11) 30.6 33.5

R157 (2014/15/16) 25 19.9

R186 (2025/26/27) 17.6 10.3

R189 (ILB, 2013) 2.9 0.9

R197 (ILB, 2023) 2.3 2.3

* Market turnover/nominal outstanding issue

13 Fiscal conservatism drives sovereign Fiscal conservatism drives sovereign ratingrating

Given a budget deficit overhand from political settlement, reducing public sector debt was the anchor input of a wider strategy to reduce inflation and liberalise the economy

The financial payback for a steady lowering in debt service costs has been a steady improvement in SA’s credit rating, from “junk” to “investment” grade in the last decade

source: SA National Treasury source: SA National Treasury, Standard & Poor

30

35

40

45

50

559

0/9

1

91

/92

92

/93

93

/94

94

/95

95

/96

96

/97

97

/98

98

/99

99

/00

00

/01

01

/02

02

/03

03

/04

04

/05

05

/06

06

/07

-8

-7

-6

-5

-4

-3

-2

-1

0Net govt. debt/GDP (%, lhs)

Budget deficit/GDP (%, rhs)

3

4

5

6

96

/97

97

/98

98

/99

99

/00

00

/01

01

/02

02

/03

03

/04

04

/05

05

/06

06

/07

Debt costs/GDP (%)

S&P Credit Rating

BB+

BBB-

BBB/better?

Projected

Projected

14 Shifting issuance bias in SA bond Shifting issuance bias in SA bond marketmarket

SA’s improving credit rating has continued to pave the way for more global issuance, subject to Treasury’s self-imposed current 80% (local)/20% (foreign) funding “rule”

Improving deficit and debt profiles, coupled with a steadily rising share of foreign issuance has substantially removed a crowding-out effect to abet corporate issuance

source: SARB source: BESA

0

10

20

30

40

50

60

70

80

90

1001

99

4

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

Total foreign debt (ZARbn)

0

10

20

30

40

50

60

70

2001 2002 2003 2004

Corporate bond market cap. (ZARbn)

15 Cash-flows funding private capital Cash-flows funding private capital intensity intensity

With aggregate savings, a lower budget deficit has on a relative basis been taken up by lower household saving, reflecting low income tax cuts and rising retail credit intensity

For SA’s financial intermediaries, as companies have met rising fixed investment needs from flush cash-flows, this has meant growth in bank credit relative to bond issuance

source: I-Net Bridge; Deutsche Securities source: I-Net Bridge; Deutsche Securities

Share of aggregate savings (%)

General government

Households

Corporates

Private vs public sector capital formation (1995 Rbn)

Private

Public

%/GDP Pvt. Pub. 1970 10.0 9.21980 10.9 10.61990 9.6 5.72000 11.7 3.909/’03 12.8 4.2

16 Maturity profile and yield spread Maturity profile and yield spread dynamics dynamics Towards a smoother SA issuance profile

Foreign issues: smallness means lumpiness

Country premia more relative than absolute

Credit vs. liquidity risks in corporate spreads

Spreads consistency reflects efficient market

A note on inflation-linked bonds (ILBs)...

17 Towards a smoother SA issuance profile Towards a smoother SA issuance profile

source: SARB

0

5

10

15

20

25

30

35

20

04

/05

20

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/06

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/07

20

07

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20

34

/35

Maturity profile of domestic marketable bonds (ZARbn)

18 Foreign issues: smallness means Foreign issues: smallness means lumpiness lumpiness

source: SA National Treasury

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.02

00

4

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20

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20

08

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09

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17

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18

20

19

20

20

20

21

20

22

Maturity profile of government foreign debt (US$bn)

19 Country premia more relative than Country premia more relative than absolute absolute

While SA’s sovereign risk premium has improved since 1996, so too have many other country ratings, especially the EU convergence trades, which have leap-frogged SA

Significantly, in the tightening of EM spreads since 4Q02 to risk levels last seen in 1997 (i.e. pre-Asian crisis), SA’s credit returns have mostly mirrored those of EM’s generally

source: I-Net Bridge; Bloomberg; Deutsche Securities source: I-Net Bridge; Bloomberg; Deutsche Securities

0

100

200

300

400

500

600

700

800

1996 1997 1998 1999 2000 2001 2002 2003 2004

Country risk premium* (bp)

Average: 246bp

350

450

550

650

750

850

950

1050

Apr-

02

Jul-

02

Oct

-02

Jan-0

3

Apr-

03

Jul-

03

Oct

-03

Jan-0

4

50

100

150

200

250

300

350

EMBI+ (LHS)

SA US$ 10Y (RHS)

Spread over USTs (bp)

* 10Y SAUS$ - 10Y UST

20 Credit vs. liquidity risks in corporate Credit vs. liquidity risks in corporate spreads spreads

Sub-sovereign (parastatal) and corporate debt reflect appropriate spreads of underlying credit or earnings risk: tighter/stable for annuity cash-flow operations such as utilities

Tighter parastatal spreads also reflects implicit govt. backing of default risk. As elsewhere, credit quality determines relative spread elasticity to benchmark SAGB yield dynamics.

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I-N

et

Bri

dge;

Deuts

che S

ecu

riti

es

-20

0

20

40

60

80

100

120

140

160

Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04

Corporate (NED1)

Parastatal (WS03)

Spreads to SAGB equivalent (bp)

21 Spreads consistency reflects efficient Spreads consistency reflects efficient market market

For a yield curve with reliable leading indicator properties, it follows that changes in relative spreads reflect appropriate risk-adjusted “bets” of bond investors

Where liquidity has been dominant in the 5-year and 10-year areas of the curve, most directional “bets” are in terms of 2-year/5-year or 2-year/10-year spread trades

sourc

e:

Deuts

che S

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riti

es

-300

-200

-100

0

100

200

300

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

5/2 yr spread

10/2 yr spread

10/5 yr spread

2-year 5-year

5-year Mean: 34bpSD: 73bp

10-year Mean: 51bp Mean: 17bpSD: 96bp SD: 29bp

22 A note on inflation-linked bonds A note on inflation-linked bonds (ILB’s)...(ILB’s)...

In tandem with the introduction of the inflation target in 2000, National Treasury has issued four ILBs across the maturity spectrum, currently accounting for 6% of issuance

While still relatively illiquid, it is possible to derive from their real yield differentials distinct discounted future inflation expectations for comparison to consensus forecasts

source: SARB; SA National Treasury; BESA source: I-Net Bridge; Deutsche Securities

0

1

2

3

4

5

6

7M

ar-

00

Sep-0

0

Mar-

01

Sep-0

1

Mar-

02

Sep-0

2

Mar-

03

Sep-0

3

ILB issuance as % of cumulative total net issuance

4

5

6

7

8

9

Mar-

00

Sep-0

0

Mar-

01

Sep-0

1

Mar-

02

Sep-0

2

Mar-

03

Sep-0

3

10y

20y

5y

30y

Breakeven inflation rates (%)

23 FX risk; benchmark and ownership FX risk; benchmark and ownership issues issues SA bonds are better insulated from FX risk

SA in EM: Small in bonds but big in equities

FPI flows reflect benchmark characteristics

Foreigners are mature owners of SA assets

Structural bond ownership patterns persist

24 SA bonds are better insulated from FX SA bonds are better insulated from FX risk risk

The recent profile of FX risk is ambiguous: on one measure (relative yield derived), SA currency risk has declined but on another (FX volatility derived) it has increased

Since the former is more stable, one could conclude that local yields have become less sensitive to “pure” FX risk, a conclusion consistent with an improving sovereign rating

source: I-Net Bridge; Deutsche Securities source: Deutsche Securities

0

200

400

600

800

1000

1200

1400

199619971998199920002001200220032004

Currency risk premium* (bp)

Average: 537 bp

* 10Y SAGB -10Y SAUS$ 0

5

10

15

20

25

1996 1997 1998 1999 2000 2001 2002 2003

Annual volatility of ZAR/US$ (%)

25 SA in EM: Small in bonds but big in SA in EM: Small in bonds but big in equities equities

Dedicated capital flows are an important source of capital for EM’s. For such investment, bond investors are benchmarked to the EMBI+ and equity investors by MSCI’s EMF

Financial sanctions and an alternative foreign debt restructuring left SA with a low EMBI+ weight but established, large companies ensured SA a high MSCI EMF weight

source: JP Morgan source: Morgan Stanley Capital International

0

5

10

15

20

25M

oro

cco

Nig

eri

a

Pola

nd

Ukr

ain

e

Pan

am

a

Sou

th A

fric

a

Arg

en

tin

a

Ecu

ad

or

Bu

lgari

a

Mala

ysi

a

Peru

Ven

ezu

ela

Colo

mb

ia

Ph

ilip

pin

es

Tu

rkey

Ru

ssia

Mexic

o

Bra

zil

Benchmark EM bonds:Weight in EMBI+ (%)

0

2

4

6

8

10

12

14

16

18

20

Colo

mb

iaV

en

ezu

ela

Paki

stan

Jord

an

Moro

cco

Eg

yp

tC

zech

Rep

ub

licPeru

Ph

ilip

pin

es

Arg

en

tin

aH

un

gary

Pola

nd

Tu

rkey

Ind

on

esi

aC

hile

Th

aila

nd

Isra

el

Mala

ysi

aR

uss

iaIn

dia

Mexic

oC

hin

aB

razi

lTaiw

an

Sou

th A

fric

aK

ore

a

Benchmark EM equities:Weight in MSCI EMF (%)

26 FPI flows reflect benchmark FPI flows reflect benchmark characteristicscharacteristics

Following the abolition of the Finrand and inclusion in benchmark indices, SA could capitalise on FPI as the main source of financing a renewed current account deficit

Given SA’s apposite benchmark status in bonds and equities has seen latter dominate FPI inflows, but “off-index”, opportunistic bond inflows can be temporarily large

source: I-Net Bridge, Deutsche Securities source: I-Net Bridge; Deutsche Securities

Bonds

Equities

13-week accumulationBonds

Equities

US$ billion

US$ billion

27 Foreigners are mature owners of SA Foreigners are mature owners of SA assets assets

Foreign asset and liability position (for latest 2001 data) confirms foreigners’ preference for domestic equity over bonds, with a notable public vs. private source of funding split

Significantly, in US$ terms, it would appear that without further structural changes to SA’s asset markets, there is little scope for foreigners to raise their ownership stakes

source: SARB source: SARB

0

2

4

6

8

10

12

14

16

18

1995 1996 1997 1998 1999 2000 2001

Public authorities Public corporations

Banking sector Non-bank sector

Gross foreign ownership of domestic debt (US$bn)

0

5

10

15

20

25

30

1995 1996 1997 1998 1999 2000 2001

Banking sector Non-bank sector

Gross foreign ownership of domestic equity (US$bn)

28 Structural bond ownership patterns Structural bond ownership patterns persist persist

Even as the PIC has sought to diversify its historic asset allocation bias from bonds to equities, this has been achieved via cash-flows, especially during debt-buyback years

By being on the other (asset allocation) side of the market, the PIC posted impressive relative returns from its high bond exposure, helping GEPF to close its net funding gap

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SA

RB

; I-

Net

Bri

dge

0%

20%

40%

60%

80%

100%

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

PIC SARB Banks Non-bank private sector

Ownership of long-term domestic government debt

29 Some conclusions and suggestionsSome conclusions and suggestions Treasury deserves plaudits for macro restructuring that has helped

to stabilise economy and consolidate the bond market

It remains critical that inflation targeting success completes this contribution to a sustained re-rating in SA’s real debt costs

Lower real yields should be matched by further sovereign credit re-rating, and thus an ability to unwind bond market overhangs

Critical to this process will be: boosting bonds’ benchmark asset allocation; reducing PIC dominance and more off-shore issuance

This would facilitate more foreign participation as well as boost capacity for bond financing of new net fixed capital formation

The bond market is merely one financial intermediary for savings and investment, which remain a function of economic growth

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Deutsche Bank research ratings key

Buy: Total return expected to appreciate 10% or more over a 12-month period.

Hold: Total return expected to be between 10% to ‑10% over a 12-month period.

Sell: Total return expected to depreciate 10% or more over a 12-month period.