The 2021 Budget review brought relief to individual taxpayers and corporations as National Treasury scrapped planned tax increases to raise additional R40 billion in revenue that was stated in the Medium Term Budget Policy Statement (MTBPS). For the first time in six years individuals received tax relief with bracket creep also being avoided as tax brackets were lifted by 5%. Revenue came in almost R100 billion better than October projections, resulting in smaller than projected budget deficit. The current fiscal year deficit is at 14% of gross domestic product (GDP) versus 15.7% estimated previously and fiscal year 2021/22 budget deficit projection also came in lower than expected near 9.3%. The macro economic assumptions on growth, tax buoyancy and inflation appears credible. If spending is adhered to and revenue collections play out accordingly, the debt/GDP profile could stabilise at 88.9% in 2025/26 rather than the peak of 95.3% previously estimated.
The biggest headline is the R380 billion bond issuance estimate being revised down sharply versus R520 billion in 2020/21, and consensus sat around R430 billion just ahead of the budget. This is equivalent to R6.4 billion per week for South African Government Bonds (SAGBs) auction size plus linkers (plus assumed 45% non-comp), i.e. R4.8 - R5 billion nominal new auction size every Tuesday from R6.6 billion currently. The local bond market is likely to look to consolidate recent gains until actual new weekly auction sizes announcement is made. This could occur before the end of the first week of March within context of a volatile rates backdrop from core bond markets which is experiencing a disorderly sell-off on higher inflation expectations with real yields (US TIPS) leading the way.
For National Treasury budget implementation risks remain due to assumption that state worker wages will be frozen in the upcoming three years, which we deem to be overoptimistic and could result in MTBPS showing fiscal slippage again later this year. A mere 1.5% increase awarded in social grant payments also seems too conservative. As was broadly expected, the lower deficit numbers over Medium Term Expenditure Framework (MTEF) implies lower borrowing requirement and with prefunding post COVID-19 emergency fiscal package, the Treasury-bill, SAGB and Inflation-Linked Bond issuance will imply reduced auction sizes in the coming weeks and months. The market has applauded and reflected this in flatter curves. A positive surprise was that corporate tax rate is expected to be lowered to 27% from April 2022, and together with no outright increases on PIT, illustrates a more pro-growth oriented fiscal policy setting which will be welcomed by markets.
National Treasury analysis indicates that increasing issuance for bonds maturing between three and 17 years may reduce borrowing costs, and that maintaining an average term to maturity of 9.5 years to 14 years reduces refinancing risk. Weighted average term to maturity (WATM) of issuance is projected in budget document to be near 11.8 years in 2021/22 versus 12.2 years in 2020/21. The period 2020/21 was artificially low on average due to three months of very short issuance during the crisis. The budget document indicates that there will be a shorter duration as well as lower nominal of issuance. There is also a commitment to a Sukuk bond in ZAR which will be part of that nominal issuance. No commitment to a floating rate note (FRN) although mention was made that it could still be on the table in our view.
Market impact and outlook
A sharp rally during the early part of the budget speech with curve bull flattening and ultra-long end rallying close to 37 basis points. This was met with some selling as many market players opted to bank profits on a better than expected outcome on borrowing requirement and issuance reduction.
We expect the best levels set in Wednesday’s session to hold and lows on yields to be in until further notice. However, we believe bonds will continue to enjoy support from large month end coupon flow and lower auction implementation. But we do also see limited scope for substantial build gains beyond Wednesday’s yield lows due to upward pressure in global core bond markets that are looking ahead to improving economic growth, higher actual inflation outcomes and widening inflation expectations.
We think that curve flattening is still possible in near to medium term with ultras outperforming short end and belly (three-year-seven-year sector) where issuance will be concentrated. On a six to 12 month view we remain concerned about renewed curve steepening due to risk of SA fiscal sustainability and further debt downgrades if fiscal outcomes disappoint. This, together with Fed quantitative easing tapering and eventual fed funds rate hikes becoming market focus in 2022 and 2023, will serve to heighten SA funding pressure as global financial conditions tighten again which we think is a story for later this year when markets thinks to transition into 2022 but remains highly Fed dependent in terms of their communication which remains highly accommodative for now which will attempt to keep markets calm despite reflation and reopening themes playing out in rising core bond market yields.
The projected debt profile in outer years and the steady upward drift in debt and rising debt service costs, rising inflation expectations and eventual upward move in policy rates by SARB suggests local bond yields trading well below fair values for investment horizons of 12 months or longer. We would use post budget rallies in bonds in quarter two to reduce duration exposure from near to medium term constructive views or consider protective overlays to portfolios for a more challenging second half of 2021.