Downgrades: The R140bn question

In a Reuters poll published earlier this week, 13 out of 25 economists surveyed expect at least one of the major ratings agencies to cut South Africa’s local currency debt to below investment grade later today. Both S&P and Moody’s are expected to make announcements within the next 24 hours. On Thursday smaller agency Fitch said it was keeping SA’s local and foreign debt at sub-investment grade with a stable outlook.

A lot of the focus in the build-up to the ratings decision has been on the impact that a downgrade would have on South Africa’s currency and bond yields. This is because if both S&P and Moody’s downgrade South Africa, the country would fall out of the Citi’s World Government Bond Index (WGBI).

This is expected to force a number of foreign investors to sell their local bond holdings, either because they are held in passive funds tracking the WGBI or they are held in active funds that reference the WGBI in some way. A major selloff would send bond yields higher and see a drop in the value of the rand as investors moved money out of the country and into other currencies.

RMB economist Ilke van Zyl says that there is a range in which such outflows would fall. Her calculations suggest that if only one agency downgrades the country’s credit rating, the outflows would be between R7.6 billion and R67.6 billion. If both S&P and Moody’s downgrade South Africa, the outflows will be between R75 billion and R141.1 billion.

These figures assume that no funds re-enter South Africa, given that when the country falls out of the WGBI it would then be included in other ‘high yielding’ or ‘junk bond’ indices.

A sudden stop event

Senior economist at the Bureau for Economic Research, Hugo Pienaar, says that if you assume that all foreign bond holders who reference the WGBI are forced sellers and that no other foreign investors are willing to pick up those bonds, this would equate to a ‘sudden stop event’ of foreign capital.

“R140 billion outflow of capital from South Africa would be a very big hit, given that we are running a current account deficit around R120 billion a year,” Pienaar points out.

However, he thinks this is too extreme an assumption to make.

“What we are increasingly seeing is that there are a number of investors who are prepared to buy junk rated bonds as long as they are compensated for the risk through higher interest rates,” Pienaar notes. “Some fund managers have also mentioned that there may be foreign investors who have a number of funds, and while the one fund’s mandate is the WGBI they have other funds that do not have such strict mandates and so they can simply move their South African bonds from one fund to the next. If this happens, of course you won’t get that big outflow.”

It is worth noting that the South African bond auction on November 15 was three times oversubscribed. This shows that there is still an appetite for high yielding local bonds, which are already pricing in a fair degree of risk.

How much is already in the price?

Albert Botha, the head of fixed income portfolio management at Ashburton Investments points out that the spread on South African bonds against US Treasury bonds has gone up by ‘at least 100 basis points’ over the course of 2017.

“Our bond yields are up a full percentage point since the recent lows in September, and at the same time the US 10 year yield is up around 0.2% at 2.35%,” says Botha. “So a lot of the risk around the anticipation of moving from the WGBI has already happened.”

He acknowledges that the rand has not moved as much, but there are other factors supporting the local currency. Most notably, emerging markets have been in favour amongst global investors and therefore emerging market currencies in general have been stronger this year. This is also why the market reaction after the dismissal of Pravin Gordhan as minister of finance was reasonably muted.

“Events don’t occur in a vacuum,” says Botha. “By any objective set of measures the reshuffle in March was a more adverse political event than the firing of minister Nene in December 2015, but the market reaction was much smaller. The difference was that the firing of Nene occurred during a time when there was already a generally negative sentiment towards emerging markets.”

Every asset has a price

It’s also worth noting that the rand trades around $55 billion (R763 billion) every day, so on that basis the flows out of South African bonds may be quite small. However, RMB currency strategist John Cairns notes that as a single event it is large and will move the market.

“It’s also a psychologically important issue,” he notes. “The market has a big focus on it.”

This impact on sentiment will be important. It will also be a significant factor in how quickly, or otherwise, any impacts are reversed.

“There is a truism that every asset has a price, the trouble is in finding what that is,” Botha explains. “Historically, in the run up to a downgrade, at a downgrade, and just post it you see the peak in bond yields. That is quite often followed by a retracement over subsequent months.”

Whether or not this will be the case in South Africa, however, remains to be seen.

“The difficulty is that quite often the retracement happens due to a policy response,” Botha explains. “In South Africa, given the uncertainty in local politics, we will have to wait at least until the outcome of the ANC’s elective conference. It’s more likely that a policy response may only come in the budget in February, which could mean that bonds trade at relatively high yields from now until then unless there is substantial good news that the market reads very positively.”

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