SOUTH AFRICA’S DEBT DILEMMA — RISKS AND OPPORTUNITIES

South Africa’s sovereign fundamentals have deteriorated alarmingly over the past decade — so much so that the country now finds itself entangled in a debt crisis. Portfolio manager FARZANA BAYAT looks at the implications of the debt dilemma and the investment strategies Foord employs to protect investor capital while yielding inflation-beating returns.

Poor economic management has burdened the South African economy with seemingly unending challenges: power shortages, transportation bottlenecks, political uncertainty, stagnation in growth, high unemployment rates, under investment, overspending and lack of fiscal consolidation. The result has been escalating debt levels.

South Africa’s debt burden has multiplied in recent years. In 2006, the country's total debt was a modest R500 billion. By 2011, this had grown to R1 trillion and escalated to R4.7 trillion by 2022. It is expected to approach a whopping R6 trillion by 2025.

Of course, the economy has also grown — not but proportionately. Relative to the country's Gross Domestic Product (GDP), the debt burden increased from a conservative 30% of GDP to a worrisome 70% of GDP over this period. If not for the statistical rebasing of GDP, we would be closer to 80% now.

Worse though, is that South Africa currently spends 20% of tax revenue on servicing debt. This debt service cost crowds out other much needed expenditure — crippling the government’s ability to invest in essential sectors like healthcare and education. Consequently, we find ourselves caught in a debt trap. The only way out is through high growth (unlikely), inflation (probable) or drastic curtailing of government spending (politically unpalatable going into elections).

Globally, there has been a surge in sovereign debt and debt defaults, triggered by excessive borrowing during periods of low interest rates. Now, with the interest rates rising, several countries are struggling to service their debts. Additionally, borrowing in US dollars has become costlier due to the strengthening of the US dollar relative to emerging market currencies.

According to the International Monetary Fund, almost half of African countries are in debt distress as of 2023. South Africa has not been declared in debt distress yet, but, given its debt trajectory, it could soon be headed there.

Analysing South Africa’s ability to repay debt by considering factors such as debt and interest cover metrics, and the country risk premium, South Africa ranks 15th among 25 heavily indebted countries. It fares worse than countries like Nigeria, Morocco and Turkey, which are themselves in precarious positions. There is a looming risk of a sovereign debt crisis in South Africa, and investors should be cautious.

There are primarily two methods to navigate oneself out of a debt crisis, depending on the nature of the debt. If a country has mainly offshore debt, restructuring the debt or imposing haircuts (see DID YOU KNOW?) are options. However, if the debt is primarily in local currency, as in South Africa's case, then the path of least resistance is to run with higher inflation — money printing causes inflation, which causes nominal GDP to increase, thereby reducing the debt-to-GDP ratio. The drawback to this strategy is a substantially weaker currency, which itself perpetuates inflation.

Given that South Africa's path out of the debt crisis might entail higher inflation, Foord employs an investment strategy that includes exposure to several resilient instruments in its fixed income portfolios:

• Floating rate notes: As interest rates must rise to counter inflation, investments in floating rate notes can be beneficial. These instruments reset quarterly based on prevailing rates and offer a term spread.
• Inflation-linked bonds (ILBs): With inflation expected to rise, ILBs are the only instrument to offer full inflation protection and are an attractive investment if real yields remain stable.
• Offshore assets: These offer protection against currency depreciation, which is a probable outcome of structurally higher inflation.
• Convertible bonds: These are debt instruments that can convert into shares at a future date. Regulations allow their inclusion in fixed income funds, and they tend to rise with rising equity prices.

In contrast, fixed rate government bonds can be a poor investment if inflation rises more than expected. In this scenario, rising bond yields will force bond prices down (bond prices move inversely to yields). The result is capital loss — if you don’t hold these bonds to maturity.

In the Foord Flex Income Fund, we own a blend of these assets to protect capital and produce inflation-beating returns. The fund is currently yielding 10.5% with a very low level of downside risk. It primarily holds short-dated, high credit-quality assets, and avoids risky credit exposure (the bulk of instruments are rated AAA and AA and over 80% of the portfolio is invested in senior bank and government paper). Given that inflation risks are to the upside, we prefer ILBs over fixed-rate government bonds.

South Africa's debt crisis is a concern that investors must closely monitor. The country's debt has risen alarmingly and its ability to service this debt is deteriorating. Foord's safety-first investment style aims to safeguard capital and take advantage of opportunities only when the risk is warranted. By diversifying investments and understanding the economic landscape, fixed-income investors can still navigate these challenging times with caution and prudence.