What does the downgrade mean for South Africa?

On Friday, 27 March 2020,
news broke that rating agency Moody’s cut South Africa’s sovereign credit
rating to sub-investment grade. South Africa now has a sub-investment rating
from all three major international rating agencies. What will this mean for South
African bonds?
Let’s first look at what it
means to be downgraded.
Think of it as a credit score
from your bank manager – the less likely you are to default on your debt
repayment, the better your score will be, whereas a weak score would indicate
that you are more likely to default, and not be able to repay your debt.
When you have a bad credit
score and you are seen as someone that could potentially not repay a loan, the
establishment extending the credit to you assumes more risk in lending the
money to you (as opposed to someone with a better credit score). Therefore, the
credit provider will charge a higher interest rate to be compensated for the
increased level of risk it assumes in lending you the money.
In the same manner, South
Africa is rated on its ability to repay its debt and is charged more when it
has a bad credit rating. The downgrade, therefore, raises the question of how
much more South Africa will have to pay for its debt going forward.
Already priced-in?
When comparing South African
bonds to other emerging markets, South Africa was paying more for its debt
compared to other emerging markets (see graph on the next page) even before the
downgrade. This means that investors already viewed South Africa as
non-investment grade and our bond yields had adjusted to reflect this.
As an example, you can buy a
10-year South African government bond and earn a real yield (yield after
inflation) of 4.7% compared to a 10-year Brazilian bond that only pays a real
yield of 2.6%. Brazil has been sub-investment grade since 2016 and in theory,
should be paying more for their debt than South Africa.
So, the question begs – why has South Africa been paying
more for its debt than other emerging markets that are sub-investment grade?
It is not due to the poor
economics of South Africa and rising debt levels as all countries have debt and
most of our peers have higher debt levels than South Africa. We would argue
that global investors do not like uncertainty and the fact that South Africa
has been threatened with a Moody’s downgrade for the last 18 months. This led
to global investors taking a wait and see approach rather than investing in our
sovereign bonds.
Where to from here?
Currently, 10-year South African government bonds are
yielding close to 12%, which means that if you buy a 10-year South African
government bond now and hold it until maturity, you will receive coupons every
year of 12%. Considering that inflation is close to 4.5%, this is a healthy
return on investment and equates to a real yield (after inflation) of close to
7.5%.
It’s worth noting that many
developed market sovereign bonds currently have negative real yields. This
means that over time the value of your money will decrease if you invest in
many developed market bonds. It’s no secret that investors need positive real
returns from their investments in order to meet their liabilities.
A concern highlighted by many market participants is the
fact that South Africa will lose its place in the World Government Bond Index
(WGBI) following the downgrade from Moody’s to sub-investment grade. This has
been one of the consequences of the downgrade that has left many investors
worried, in that it would lead to foreign investors being forced to sell South
African bonds and cause the price to fall. While this concern is valid, there
are two important factors to consider.
Firstly, many foreign investors
left our market in March due to the risk-off trade and panic selling caused by
the COVID-19 virus. Secondly, although South Africa will exit the WGBI (where
we made up less than 0.5% of the index) we will now be included in
sub-investment grade indices such as the Global High Yield index. In the latter
index, South Africa will have a larger weight of 5% and be an attractive option
for investors looking to invest in this index.
In addition to this, government
bonds provide portfolio protection against a strengthening rand. While the rand
has weakened dramatically over the past few weeks, we believe it is now looking
oversold. We are also confident that investors will reinvest into our market
once the COVID-19 noise subsides.
In closing
We believe that, even though
market conditions are challenging, it is precisely at these times that one
needs to focus on the fundamentals and take advantage of mispricing and golden
opportunities.
Achieving positive portfolio outcomes continues to be our
long-term focus, which is driven by a willingness to be different from others
and in applying a disciplined investment approach. In our opinion, the Moody’s
downgrade was priced in before March and South African government bonds
currently present an excellent investment opportunity.