The Aquila Column
Most investors and borrowers know about the impact of interest rate cuts. For investors, particularly those on fixed incomes, an interest rate cut means lower returns. Meanwhile, for those taking on debt—whether through bond financing, vehicle purchases, or higher purchase agreements—the cost of borrowing will decrease. However, less is understood about how an interest rate cut affects everyday investors’ portfolios, particularly through government bonds.
With the South African Reserve Bank (SARB) poised to cut interest rates by 25 basis points to 8.00% on September 18, 2024, investors are already speculating about the broader market impact, particularly on government bonds. Bonds, as we know, are debt instruments issued by the government to finance public spending, and they come with fixed interest payments known as coupons. The relationship between interest rates and bond yields is well-established, and a lower interest rate will likely ripple through the bond market in complex ways.
The Basics: What Are South African Government Bonds?
South African government bonds are interest-bearing financial instruments issued by the state, with a commitment to pay periodic interest and return the principal at maturity. Investors can access a variety of bonds, including short-, medium-, and long-term bonds, such as the R186 (10-year), R2030 (11-year), and R2040 (20-year) bonds. These bonds are critical components of many local and international portfolios.
In local bond funds, government bonds often make up 50–60% of the portfolio, as they are seen as relatively safe, though not without risk. In global funds, exposure to South African bonds tends to be much lower, around 5–10%, primarily due to currency and economic concerns.
Interest Rate Cuts and Their Immediate Impact on Yields
If SARB lowers the repo rate to 8.00%, the immediate expectation is a decline in bond yields. Yields move inversely to prices; when interest rates fall, the price of existing bonds rises as their fixed coupon payments become more attractive relative to new bonds issued at the lower rate. In essence, investors are willing to pay a premium for existing bonds with higher returns.
The yield on government bonds, especially those with longer maturities, such as the R186 or R2030, is likely to decline. Lower yields mean lower returns for investors entering the market, although those holding bonds will benefit from the price appreciation.
Investment Sentiment: Shifting Preferences
Lower interest rates tend to buoy investor sentiment towards riskier assets, such as equities and corporate bonds. In this environment, South African government bonds might see an influx of local demand, as investors look for higher returns than they can achieve in the now lower-rate environment of bank savings or other low-risk instruments.
However, there is a caveat. The rate cut signals a dovish monetary stance, which could indicate future economic uncertainty. This may keep a portion of cautious investors tethered to the relative security of bonds, especially if inflation remains under control.
Foreign Investors: A Currency Conundrum
The reaction from foreign investors is more nuanced. Typically, a rate cut can weaken the local currency, as lower interest rates reduce the appeal of holding assets denominated in that currency. The South African rand could see some downward pressure, making government bonds less attractive to foreign investors who could face reduced returns when converted back to their home currency.
That said, foreign investment in bonds has often been driven by yield differentials. Even with a rate cut, South African bonds may still offer higher yields than bonds from developed markets, where rates have been at historically low levels.
A Delicate Balance Ahead
Overall, a SARB rate cut is expected to create a supportive environment for government bond prices in the short term. However, as yields fall, so too does the income potential for new investors. Additionally, foreign investors will weigh the impact of a weaker rand against the still relatively attractive yields.
The bond market will likely remain a key focus as investors assess whether this rate cut is a one-off or the beginning of a more accommodative policy cycle. Should further rate cuts follow, yields could compress even more, reducing the attractiveness of South African government bonds.
Ultimately, investors in South African bonds must stay nimble, ready to respond to a shifting landscape where local monetary policy and global capital flows collide.
