One of the greatest difficulties most fixed income investors face is how to provide enough income to meet their lifestyle needs without also taking on the higher risk typically associated with higher yielding investments. Putting money to work where the risk of loss is lowest typically means receiving the least amount of payback for its use. With ten year US Treasuries yielding only slightly better that half the most recent 3.8% (CPI) inflation rate, they appear to be a very “safe” way to only lose about 2% per year (without calculating any state or local taxes.) If the loss of principle is the foremost concern, then inflation and the loss of buying power (implying a devaluation of the dollar) must be close runner ups. However, in our research of corporate debt instruments utilized around the globe, we have found a remarkable number of short term, AAA rated, corporate bonds denominated in foreign currencies, such as the Rabobank South African rand bond presented here, that have extremely attractive yields when compared to similar US dollar denominated corporate debt.
Corporate Bond linked to the South African Rand
Netherlands based Rabobank has bonds, denominated in the South African rand, that currently has a yield of over 6% for 30 months. The high yield and short maturity of this rand bond, when considered with its extremely strong AAA rating, compares very favorably in relationship to other high yield instruments in our Foreign and World Fixed Income holdings, and we consider the recent weakness of the rand an excellent opportunity for increasing an exposure to the rand in our basket of foreign fixed income holdings. While the dollar appears to be greatly benefiting from the ongoing European banking crisis and removal of the Swiss franc as a “safe haven” currency, we believe the dollar’s longer term weakening trend against many other world currencies remains a major concern for investors seeking protection against further erosion of the its buying power, and we view the recent strengthening of the dollar as a great opportunity to diversify into economies that continue to show good growth potential in spite of the recent financial turmoil.
Wealth Preservation Concerns
Wealth preservation, or protection from wealth destruction, appears to still be the name of the game in the West as long as yields of the safest investments, US Treasuries, remain submerged well below inflation rates. Several financial pundits have speculated that the reason gold is being bid up has less to do with a love for the metal that it does the world’s growing distrust of the financial system and the incubating possibility of extreme inflation of the US dollar and other major currencies. Whether the Fed’s manipulation of interest rates to zero combined with the continued printing of fiat money, or whether the European Central Bank’s apparent inability to resolve its problems is more responsible for the growing mistrust might be as easily resolved with a coin flip than with significantly more pragmatic (and strenuous) reasoning. While gold (or other precious metals) do offer a certain storage of value, it’s also a reflection of money that has been intentionally “sidelined” to await a better opportunity of use. If or when solely relied upon to meet everyday living expenses, it eventually becomes depleted (by you or your heirs.)
Although Greece hasn’t yet technically defaulted, it appears that it may have already in the eyes of investors, and the market is now forcing European leaders to quickly decide how they want the rest of the sovereign debt crisis to play out. Consequently, a flight to US dollars has resulted from the euro’s demise. Adding to the frustration of fixed income investors not knowing where to put their dollars to work, are the historically low rates of returns being offered to the plethora of money evidently flowing in and around nearly anything that’s “better than nothing.” Worth repeating from last week’s issue, however, is Wall Street Journal’s recent reporting of the Congressional Budget Office statement that it anticipates the trade-weighted exchange value of the U.S. dollar to decline at a moderate pace over the next 10 years.
Here at Durig Capital, we have undertaken the effort to protect our client’s assets against the persistent destruction associated with an ever increasing supply of US dollars by scouring the globe in search of the soundest investments in a basket of the strongest global currencies, and it is why we have chosen the extremely high AAA rated Rabobank higher yielding, short-term South African rand bond as This Week’s Best Bond.
South Africa Economy
South Africa is a middle-income, emerging market with a rich supply of natural resources; well-developed financial, legal, communications, energy, and transport sectors; a stock exchange that is the 18th largest in the world; and modern infrastructure supporting a relatively efficient distribution of goods to major urban centers throughout the region. South Africa is the economic hub of Sub-Saharan Africa and is one of the world’s largest producers and exporters of gold and platinum. The South African economy benefits from relatively good levels of trade freedom, business freedom, and financial freedom. The regulatory environment encourages competitiveness and flexibility. Continuing integration into global commerce has led to notable increases in productivity.
Debt to GDP
GDP Growth (Q1 2011)
Total Gov Debt
*South Africa has over 100% of its total government debt in foreign reserves. The USA has less than 1% reserved.
South Africa's current government largely follows the same fiscally conservative economic policies of its predecessor, focusing on controlling inflation and attaining a budget surplus. Monetary stability is relatively good, but the government influences prices through regulation, state-owned enterprises, and other support programs by which more than a quarter of South Africa's population currently receives social grants. However, poverty is widespread, and much of the population is poorly educated and lacks access to infrastructure and services. In the most recent year, total government expenditures, including consumption and transfer payments, held steady at 27.4 percent of GDP.
Growth was robust from 2004 to 2007 as South Africa reaped the benefits of macroeconomic stability and a global commodities boom, but began to slow in the second half of 2007 due to the electricity crisis and the subsequent global financial crisis' impact on commodity prices and demand. At the end of 2007, South Africa began to experience an electricity crisis. State power supplier Eskom encountered problems with aged plants, necessitating "load-shedding" cuts to residents and businesses in the major cities. While inflation was high, averaging 8.2 percent between 2007 and 2009, it subsided to around 6 percent in 2010. Existing labor regulations are not applied effectively, and the rigid labor market has contributed to persistently high (over 23%) unemployment rates.
South Africa’s financial sector accounts for about 20 percent of GDP, and consolidation has reduced the number of domestic banks to less than 40. Capital markets are well developed and centered around the Johannesburg Securities Exchange, which is one of the world’s 20 largest in terms of market capitalization. Due to its limited exposure to the high-risk securities or the complex instruments that triggered the global financial turmoil, the overall banking system has not been severely affected by the crisis. Reflecting a significant recovery from a real GDP of -1.7% in 2009 and 2.8% in 2010, South Africa's economy is expected to grow at a rate of 3.6 percent this year, according to a report released by the SA Institute of International Affairs (SAIIA), and GDP is expected to grow at a rate of 4.3 percent in 2012, according to the African Economic Outlook 2011 report.
China overtook the United States in 2009 to become Africa's main trading partner. It has also become the main destination for South African exports since the middle of 2009 and is the leading source of imports. South Africa became a member of the BRICS - Brazil, Russia, India, China and South Africa - group last December.
Rabobank Group, established in 1898, is a Dutch based cooperative financial services provider. It offers banking, asset management, leasing, and insurance and real estate services. In the Netherlands it is a full-service market leader. Internationally, it is a leading food and agribusiness bank. Overall, Rabobank Group has approximately 59,000 employees, who serve about 10 million customers in 48 countries, and it enjoys an award-winning sustainability rating in economic, environmental, and social categories. In terms of tier 1 capital, it is among the world’s 25 largest financial institutions with over 34 billion euros and a 15.7% ratio to risk-weighted assets. With a net profit of 2.772 billion in 2010, the return on equity stood at 8.6%. Rabobank has received a triple A rating from both Moody's and Standard & Poor's since 1981, the highest ratings possible for banks, and is considered among the top 10 safest banks in the world.
Currency South African Rand
The default risk is Rabobank’s ability to perform. Given its underlying strength and AAA rating, as outlined above, it is our opinion that the default risk is very minimal realative to the currency risk of the South African rand.
The currency risk could and will affect the returns of these bonds and possibly in a negative way as it exposes investors to South Africa’s economy.
South Africa’s rand has gained nearly 20% against the dollar over the last two years, namely a result of its popular inclusion as a commodity based currency. Daunting economic problems remain from the apartheid era, and the current government is facing growing pressures from special interest groups to use state-owned enterprises to deliver basic services to low-income areas and to increase job growth. The government aims to increase farmland ownership by black South Africans to 30 percent by 2014, and its affirmative-action mandates threaten private property rights. Crime, HIV/AIDS, and high unemployment are ongoing concerns. While acknowledging that every investment vehicle involves varying elements of risk, we believe that South Africa will continue to attract foreign investment dollars and that it represents an intelligent risk to reward choice and sensible portfolio diversification.
Accessibility and Liquidity
Aside from owning various emerging market funds and ETFs that blend together various winners and losers into a mixed yield cocktail, the question arises as to how the average retail investor might own or acquire individual Rabobank South African rand denominated bonds. With a broker's assistance, individual investors can participate in Rabobank South African bonds with as low as $10,000 US dollars.
We believe that South Africa’s abundant supply of resources, which includes a rich supply of gold, will likely result in the continued expansion of their economy from a persistent global demand, and possibly even a strengthening of the rand currency. Therefore, we view the currency risk of this prominent emerging market as a prudent opportunity that we have recommended our clients take in their continued effort to diversify away from over-weighted US dollar based assets, and it is why we are adding it to our Foreign and World Fixed Income holdings.
Disclosure: Durig Capital clients may currently own these bonds.