DURBAN - On Friday, 27 March 2020 Moody’s (one of the three major credit rating agencies) downgraded South Africa’s sovereign credit rating to sub-investment grade while maintaining a negative outlook.
Fitch and S&P (the other two major agencies) both downgraded South Africa to sub-investment grade in 2017.
Moody’s highlighted the following primary drivers in coming to their decision:
1. Structural economic bottlenecks that limit GDP growth potential and employment creation
2. Deteriorating public finances and unfavourable debt dynamics.
3. The acute financial stress state-owned enterprises (SOEs) are under, particularly Eskom.
4. Uncertainty around structural reforms and implementation risk.
While the downgrade had largely been priced in by financial markets, the timing thereof could not have been worse; it came amid a wave of global risk aversion, further currency weakness and higher bond yields.
Implications
The yields on SA bonds reflect the rate at which the government can borrow money. Generally, a downgrade would be associated with a higher risk profile and result in a higher yield and consequently more expensive borrowing for the sovereign.
Additionally, the rules for certain passive indices and institutional mandates stipulate that only investment-grade debt may be held and there may be some forced selling as a result of this change in rating for South Africa. Given the current market turmoil related to Covid-19, markets have been inherently more volatile, and liquidity has been constrained. This event could exacerbate this issue in the local bond market.
Mitigating factors
In financial markets the news itself is often overshadowed by the extent to which the event was expected and consequently priced in already (the local bond market is down ~12 percent year-to-date).
The current yields on SA Bonds already compare with those of other sub-investment grade countries around the world, and as such this event does seem to be largely reflected by current prices.
Given recent market turmoil the usual quarterly rebalancing of passive indices has been delayed by a month, which should alleviate any immediate selling pressure on SA Bonds. The current level of SA Bond yields is very attractive given the low rate environment globally and yields a significant margin over inflation (approximately SA CPI + 7 percent for 10-year bonds). While the downgrade is negative, there may be investors who still find appeal in the relatively high-yielding SA debt.
Portfolio impact
The portfolio construct and strategies we run are inherently long term in nature, and consequently short-term market events do not usually have a notable impact on our portfolio positioning and strategy. This particular event is uncommon, and also comes at a time of heightened volatility.
Presently, SA Bonds are an attractively valued asset class notwithstanding the downgrade and its implications. Any further sell-off in the bond market could be used, where appropriate, to opportunistically increase exposure. Additionally, we will pay attention to the impact on the rand and take advantage of repatriating assets at oversold levels and increasing exposure during strength.
In summary, the downgrade has certainly added to the flurry of recent negative news. However, the event itself is unlikely to surprise the market – and there are many mitigating factors that may result in the downgrade being met with mixed reactions from market participants. The focus now shifts to government’s ability to effectively manage its debt profile and implement structural reforms.
Renzi Thirumalai, Head of Investments, FNB Wealth and Investments