There is life, and liquidity, after WGBI exit
Martin Richardson and Varushka Singh
This article first appeared on businesslive.co.za 13/12/2020.
It is almost nine months since SA lost its last investment-grade credit rating, causing it to be ejected from the FTSE World Government Bond Index (WGBI) and prompting a sell-off of its government bonds as the last of the WGBI tracker funds exited their positions.
It was an event that had been long anticipated and long feared. The market had been positioning for a downgrade since the second quarter of 2018. This finally happened in March, just as the Covid-19 pandemic sparked panic in markets around the world and SA entered its own tough lockdown, though its formal departure from the WGBI took place at the end of April.
As it turned out, the worst-case estimates of how much would flow out of SA as foreign tracker funds sold off their holdings were not realised. Outflows totalled less than $5bn in the three-month period after the March 27 downgrade by ratings agency Moody’s Investors Service that triggered the WGBI exit. This was well below the $8bn-$11bn we estimated in January.
As it has turned out there is life, and liquidity, after the WGBI. Once the market normalised, inflows resumed from July. Foreign ownership of SA government bonds has recalibrated to a “new normal”, which though lower than its 50% peak, is still well above the level prior to inclusion in the WGBI in 2012. Recent weeks have demonstrated too that there is still significant appetite from foreign investors for SA government bonds in a risk-on environment.
However, the exit from the WGBI means SA’s investor base is shifting away from the historical trend of index trackers to those that focus primarily on high yields across the globe, especially given zero rates across the developed world. This has potentially material ramifications, which are already evident in the sharp steepening of the yield curve as well as in the high level of volatility in the markets.
With new international players replacing the WGBI index tracker funds, the rules of the game are changing. Economic, fiscal and monetary headlines are likely to prompt sharper and more immediate fluctuations in interest rates and the currency — and this can go in either direction, as we have seen in the “risk-on” rallies of recent weeks.
SA’s inclusion in the WGBI in October 2012 saw foreign ownership of SA government bonds jump from 31.99% of the total (excluding inflation-linked bonds) in June 2012, when SA’s inclusion in the index was announced, to 35.18%. The “Ramaphoria” after President Cyril Ramaphosa’s election then briefly resulted in foreign ownership climbing to more than 50% before it began to slide from March 2018.
That was when the market began to position for the Moody’s downgrade that was expected to follow the cut in SA’s rating to subinvestment grade by S&P Global Ratings and Fitch Ratings. Foreign ownership had already fallen below 45% by January. The long anticipation of the WGBI exit was a key reason the eventual effect was less dramatic than it might otherwise have been.
Nor was the WGBI the only index driving outflows in 2020. SA also had to contend with China’s first-time inclusion in the JPMorgan Global Bond Index (GBI). Unlike the WGBI, the GBI is ratings neutral. It doesn’t require an investment-grade rating, but the market for its constituents is required to be large, liquid and accessible to foreign investors. Liquid Chinese government bonds were included in the GBI-EM Global Diversified indices as of February 28, with a phase-in period to the end of December 2020. This reduced SA’s weighting in the GBI, which had stood at 7.2%, triggering outflows from the passive index tracker funds that were required to reweigh to align with the index, as well as the more active funds that track the index.
It is no simple matter to estimate the effect on flows of changes in the indices because not all foreign investment in SA’s government bonds is by the tracker funds — passive or active — that track the WGBI and/or the GBI. We had estimated, however, that about 20% of foreign holdings of government bonds could be attributed to the WGBI and would rebalance on a downgrade. Though market estimates ranged as high as $50bn and as low as $2bn, our calculations in January indicated a $10.8bn outflow at most (including interest payments) attributable to WGBI trackers.
Active fund managers would have rebalanced at their discretion, but we had projected a total of $5.6bn of passive outflows at the April month-end, when the WGBI rebalanced, including $3.5bn from the WGBI and $2.14bn from the GBI. However, some investors also had the option of reallocating the bonds to high-yielding funds and this could have dampened outflows in the months around the exit.
In the end, the SA bond market did see a huge R56bn outflow in March, amid turbulent market conditions that saw liquidity all but dry up, forcing the SA Reserve Bank to intervene prudently to stabilise the market. This was followed by outflows of R16bn in April and R12.9bn in May, to reach a total of about R85bn, or $4.7bn.
Clearly the immediate effect of SA’s WGBI exit on capital flows was not as bad as expected. By September, foreign bond holdings were at 34.75%. This is no lower than before SA entered the WGBI, even though bond issuance has ballooned as a result of the Covid crisis. There clearly is a solid base of foreign investors that is not index-linked.
However, the mix of investors has shifted. The Bank has cautioned that the WGBI exit would leave SA much more dependent on investor flows linked to yields rather than fundamentals, attracting a different kind of investor base that would bring with it higher levels of volatility. SA government bonds still offer one of the world’s highest 10-year yields, at 8%-9%. With “low rates for longer” remaining a broad theme globally, international investors have proved in recent months that they are willing to add SA holdings when sentiment is bullish. That’s been particularly so in recent weeks as global investors have regained their risk appetite.
However, the market has recently seen a new phenomenon, which may be where we start observing the real “post WGBI” effect. International investors returning to the SA government bond market appear to be hugging the shorter, 10-year end of the curve while domestic investors are taking advantage of higher yields in the longer, 30-year end. This potentially creates two very distinct and fragmented segments of the yield curve, with the short end heavily influenced by international investors and the long end by the domestic market, each with very different drivers of sentiment and price action.
This emerging trend towards domestic investors dominating the long end of the curve could accelerate as the government explores mechanisms such as longer-term infrastructure bonds to support their infrastructure development aspirations.
Richardson is CEO of RMB’s London branch and Singh fixed income & currency strategist based in Johannesburg.