Looking to new heights

The South African inflation-linked market is still at a relatively early stage of development, but its growth has reached a plateau, mainly due to a lack of secondary market liquidity. The challenge now is finding a way to encourage the market to reach new heights. By John Ferry

The South African government has done a good job of building a reasonable yield curve in inflation-linked securities. Since the inception of the country's inflation market in 2000, it has issued across a range of maturities, from two years to 30 years. This has been good news for certain institutional investors, namely pension funds that have long-term inflation-linked liabilities. The problem is that new issuance, although spread across the yield curve, has been in relatively short supply. What's more, the issuance that has emerged has tended to be soaked up by a small number of pension funds, which then sit on that paper until maturity. Both elements have combined to hamper the development of a liquid secondary market in inflation securities.

"Although the government and the National Treasury have managed to build this yield curve, it is not liquid in the sense that the institutional investors that buy the inflation-linked bonds to match long-term liabilities are not doing so for the purposes of trading in that market," says Callie Hugo, deputy head of the financial markets department at the South African Reserve Bank in Pretoria, which acts as the government's funding agent on new note issuance.

Andrew Dickens, head of foreign exchange and fixed-income trading at Absa Capital in Johannesburg, estimates that somewhere in the region of 85-90% of the total amount of inflation debt issued in South Africa is held by one or two pension funds, with the balance held by banks as hedges against inflation products they have structured. "The secondary market liquidity is almost non-existent, which means the only time we really get to see price discovery is at the monthly bond auctions," he adds.

In an attempt to stimulate trading activity, South Africa's dealing community last year approached the National Treasury to ask for a repurchase agreement facility to give traders the ability to short inflation-linked bonds. The Treasury duly made a total amount of R1 billion ($140 million) notional available via a 28-day reverse repo (where the government offers inflation-linked bonds at auction but stipulates they will be bought back again in 28 days' time), with the first reverse repo auction held at the end of August. "That was really done with the objective of creating secondary market liquidity," says Hugo.

However, this has not had the desired effect in terms of boosting liquidity. A facility capped at R1 billion notional is not big enough, say dealers. Also, because there is no guarantee that the government will roll over the facility continuously, market participants are choosing to take short positions in inflation through real-yield swaps rather than through running an explicit short position in inflation-linked debt. "It is a step forward, but our experience has been that participants in the secondary market are still only likely to show offers in bonds they already own. It hasn't had as big an impact on liquidity as we initially thought," says Dickens.

"I think it contributed to liquidity, but in general I must admit the liquidity is still not what it is supposed to be," concedes Hugo. There is, however, scope to expand the repo facility. "We will revise it soon and we will consider whether we should lengthen the maturity of reverse repos and whether we should increase the volume of reverse repos," he adds.

When the first issuers of South African inflation-linked debt emerged, dealers hoped two clear sides of the market would develop. Investors with inflation-linked liabilities or investment funds looking for real-yield returns were expected to make up the buy side, while supply was expected to come from a range of issuers with revenue streams in some way related to inflation.

The market kicked off in 1995 with the issue of an inflation-linked annuity by the N1 road toll. Further toll road debt issues followed in the late 1990s and in 2001, but these only totalled around R3 billion, according to figures from Rand Merchant Bank. The government inflation-linked bond market got under way in March 2000 with a R19.4 billion issue (see box). In total, Rand Merchant Bank estimates there are some R50 billion of inflation-linked assets outstanding in the South African market.

There has, however, been a distinct lack of inflation-linked issuance from corporates, and dealers identify this as one of the major stumbling blocks to the emergence of a liquid two-way market. "For the development of the market, you want natural payers of inflation to come to the party as well, apart from just government issuance. The government has done a reasonable job of creating the foundations for an inflation-linked market, but they have specific asset/liability management objectives that govern how much inflation-linked debt they are prepared to issue," says Dickens.

Tracy Spence, a marketer and structurer of interest rate derivatives at Absa Capital, says the underlying economics in South Africa are currently not favourable for inflation-linked issuers. "Three or four years ago, banks in other countries managed to convince issuers to issue inflation-linked paper because breakeven inflation levels there made it cost efficient for them to do so. Unfortunately, the current situation in South Africa is such that breakeven levels offer no real structural advantage to issuing inflation-linked paper over nominal paper, making it a difficult sell," she says.

South Africa's statistics agency reported on February 21 that the CPIX inflation rate, which excludes mortgage costs, rose to 5.3% in January from 5% in December. Two days later, the South African Reserve Bank auctioned R150 million of the December 2023 5.5% R197 inflation-linked bond. The auction had a bid-to-cover ratio of 2.03 and a weighted average yield of 2.69%. With the yield on the December 2026 10.5% R186 nominal bond trading at 7.23% on the same day, this implies a approximate breakeven (the spread between nominal yields and real yields, reflecting expected inflation plus a risk premium) of 4.54% - in line with the central bank's long-term inflation target of 4.5%.

There are also difficulties for real-yield buyers seeking enhanced returns. The 2.69% yield on the R197 inflation-linked bond compares with 2.34% for the January 2.375% 2025 US Treasury inflation-protected securities note. That doesn't give much of a sovereign credit premium for taking A+ rated South African debt. At these levels, it is no surprise that investors seeking yield enhancement are failing to see value in inflation-linked bonds.

The nascent inflation swaps market is also not seeing a great deal of activity. "There are maybe one or two trades a week," says Greg Ovenden, interest rate and inflation trader at Investec in Johannesburg.

With supply constraints limiting the development of a secondary market in the underlying bonds, there are few avenues for dealers to fully hedge swaps transactions. It means banks have to warehouse a certain amount of risk on their books. "We've done some trades with insurance companies where they have consumer price index liabilities," says Ovenden. These deals have gone out as far as 30 years, with the insurer paying a premium to receive Consumer Price Index-linked payments, he adds: "We can only manage this risk roughly. We take a reasonably wide margin on it because of the risks we're taking, because we don't have mechanisms for hedging it particularly effectively."

To progress further, the South African inflation market first of all needs more primary liquidity. This, together with an expanded repo facility, would open the way for speculative traders to start participating in the market - dealers say hedge funds are eager to trade South African inflation but are put off by the lack of liquidity.

However, the entry of US and European investment banks to the market could help speed things along. "We have heard talk that some of the big international banks are preparing their systems and so on to enter the market," says Ovenden. "Hopefully, with more participants the market will improve."

More participants would increase competition and bring margins down. Although the market has reached a plateau, it could just be a temporary steadying of growth before it goes on to greater heights. South Africa's dealers certainly hope so, as will the international banks lining up to get in on the action.

The South African government's inflation market

The South African government inflation-linked market got under way in 2000 with the issue of the R189 inflation-indexed bond for a notional of R19.4 billion. This came with a coupon of 6.25%, maturing in March 2013. This was followed by the R197 (R14.9 billion notional), with a 5.5% coupon maturing in 2023, the R198 (R19.4 billion notional), with a 3.8% coupon maturing in 2008, the R202 (R5.3 billion notional), with a 3.45% coupon maturing in 2033, and the WS05 (R2.5 billion notional), with a 5% coupon maturing in 2018. The latter was issued by the Trans-Caledon Tunnel Authority, the state-owned utility, to finance the Lethoso Highlands Water Project.

Absa Capital estimates that the current outstanding government debt indexed to inflation is in the region of 11% to 12% of total outstanding government debt. The South African Reserve Bank's deputy head of the financial markets, Callie Hugo, says the government has no official ceiling or limit on that proportion, adding that it will continue to issue inflation-linked securities, even though its overall funding requirement is decreasing with current budget surpluses. "The government hasn't indicated that it wants to scale down the issuance of inflation-linked bonds. As long as there is demand, it will continue to issue," he says.