Investors can strike gold in South Africa

It's still probably too early to go bottom-fishing in emerging market bond debt. After last month's shake-out, high yields are available but investors are scared to take advantage of them for fear of further drops. The income-hungry investor, though, could do worse than take a look at South Africa.

Many analysts believe that South African government bonds are now poised to rise after being pummelled along with other emerging market debt, because the outlook for slower inflation and lower official interest rates there remains fair.

Yields on the benchmark R150 (about pounds 20) bond have risen to 14.81 per cent, more than a full percentage point since emerging markets around the world started tumbling last month. That is close to the 15.1 per cent fall seen across all dollar-denominated debt in emerging markets. By comparison, the 10-year British gilt yields 6.74 per cent and 10-year US Treasury bonds yield 5.83 per cent .

Many investors say South African bonds have not deserved recent setbacks and should rise once volatility in emerging markets subsides.

"We see yields moving substantially lower," says Theo Hillen, a director responsible for emerging markets at Lombard Odier Investment Management Services. The firm bought South African bonds in recent weeks after yields rose.

One of the best reasons to expect slower economic growth and inflation next year is the weaker growth in Asian economies that set off the declines in emerging markets, investors feel. "The whole turbulence in most emerging markets should slow the economy even further," says Mr Hillen.

Many countries that export goods and services to Asia are now expected to see weaker demand for their products and merchandise. Slower economic growth is usually good for bond prices, because it reduces inflation risks.

Even without the turmoil in Asia's economies, inflation in South Africa was expected to slow, boding well for bonds. The prospects are for "lower inflation in South Africa, and with that, lower nominal interest rates," according to Graham Boyd, a strategist for UBS Securities in Johannesburg. "The balance of opinion is that it's a temporary upset in the bond market."

South Africa's official inflation rate fell to an annual 8 per cent in September from 8.7 per cent in August, according to the Central Statistical Service in Johannesburg. Although the rate remains above the 20-year low it reached in April 1996 of 5.5 per cent, many analysts and investors say high official interest rates are succeeding in putting the brakes on inflation.

Consumer prices have also been kept from rising more because businesses have been forced to keep down wage increases and boost productivity as they increasingly compete in world markets, says Mr Boyd at UBS. Slower inflation also may allow the Reserve Bank to follow last month's cut in interest rates with similar moves next year.

The Reserve Bank cut lending rates for the first time in four years, lowering its benchmark rate one percentage point to 16 per cent on 17 October. "They will probably move again," says Mr Hillen at Lombard Odier.

There's also a chance that the ratings agency Standard & Poor's will soon improve the country's sovereign debt credit rating to investment grade from one notch below that. S&P officials recently visited South Africa as part of their regular review of the country.

Many investors expect the ratings company to improve its rating for the country early next year, says Mike Lamont, head of capital markets at Standard Corporate and Merchant Bank in Johannesburg. That would probably push bond yields down, since investors demand lower compensation for the risk of holding South African bonds.

The potential drawback is that the turmoil in emerging markets could continue to spill over into the South African market. That would hurt the bonds as foreign investors pull money out, investors warn. "The instability in emerging markets could last a bit longer," says Mr Hillen. "In that case, bonds will be a bit volatile and possibly we will see yields go up even further."

Foreign investors have been net sellers of South African bonds in recent weeks, according to official figures released by the Bond Exchange of South Africa.

Foreigners accounted for 21 per cent of all trading in South African bonds by rand value in the first half of 1997, up from 10 per cent in the same period a year earlier. They bought a net R14.16bn's worth in the year to 7 November. In 1996, foreign net purchases totalled R3.8bn.

It will take a return of the overseas investor to drive bond yields lower, money managers believe. "It's been like someone saying: 'Listen, the town is on fire and all the inhabitants must leave,'" says Thys du Toit, at Coronation Asset Management.

"However, once they're on the hilltop overlooking the town they'll see there are only five houses on fire, and everyone can go back to the houses that aren't burning," says Mr du Toit. "Once sanity has returned, the investors will come back."

Copyright: IOS & Bloomberg