Who would buy SA’s junked bonds?

Now that SA’s local-currency debt has sunk deeper into junk territory, the exclusion from global debt indices and a wide selloff in the bond market appears to be a grim reality.

As expected, rating agency S&P Global joined Fitch Ratings in cutting SA’s local-currency rating from BBB- to BB+ (meaning sub-investment grade or junk) on Friday, while Moody’s kept the local-currency debt as investment grade. Although Moody’s offered SA some respite, its local-currency rating of Baa3 is on the lowest investment grade level and might be downgraded in the next three months.

S&P and Moody’s cited concerns about moribund GDP growth, political ructions that overshadow policymaking, governance issues at state-owned enterprises and government’s R50.8 billion revenue shortfall.

SA has an absolute last chance to remain in major global debt indices including the Citigroup World Government Bond Index (WGBI) and Barclays Global Aggregate Index (BGAI) as its local-currency debt is not in full junk territory given the Moody’s reprieve.

A full downgrade of SA’s local-currency debt to junk would have sparked an ejection from the investment grade-mandated indices and force a number of foreign investors to sell their local bond holdings. Foreigners’ bond holdings are held in passive funds tracking the WGBI and BGAI or active funds that reference the indices.

Analysts estimate that foreign investors hold about 42% of the government’s local currency-denominated debt, equivalent to more than R600 billion.

If Moody’s joins Fitch and S&P in downgrading the local currency debt, global passive investors would disinvest given the volatility that would follow.

Potential outflows on the WGBI are estimated to be $8 billion to $10 billion (R133 billion to R141 billion) and $2 billion to $3 billion (R28 billion to R42 billion) in the BGAI. Both indices are made up of developed market bond investors, investing in low-risk assets in Europe and the US, with small allocations into SA bonds.

As money flows out of the country, bond yields (the interest rate that investors would receive on loans to the government) would spike and the rand weaken. This might be a buying opportunity for SA bonds, said Kevin Lings, Stanlib’s chief economist.

SA ten-year government bonds were yielding 9% and around 5% after adjusting for inflation at the time of writing. An undervalued rand that has traded in a narrow range of R14 to R15/$ makes bonds attractively valued.

Potential bond buyers

As foreigners head for the exit, the local pension and insurance industry, which manages R4.6 trillion of savings investments as at June 2017, according to Association for Savings and Investment SA, could step in.

Local fund managers have had a low-risk appetite for bonds and have taken underweight position over concerns of credit downgrades to junk.

Lings said a scenario in which bond yields rise to 10% and the rand depreciates to R15/$, fund managers – with a mandate of delivering returns of inflation plus 5% to 7% – might find value in the bond market now that their fears of junk downgrades are out of the way.

“Once the market has priced in bad news, it becomes a buying opportunity. Bonds would offer a yield of 10% and real yield [inflation-adjusted] of 5% while putting money in the bank would maybe deliver a real yield of 2%. The fund manager would say ‘where am I going to get that real yield elsewhere?’ We think that local fund managers would start buying bonds,” said Lings.

Said George Glynos, chief economist at ETM Analytics: “If you believe the Reserve Bank is still good at its mandate of keeping inflation under control, which at this point they do have credibility, then bonds are a good buying opportunity.”

There are global fund managers who are purely focused on volatile emerging markets such as in Brazil, Russia, and Venezuela, Argentina and Mexico. Their thirst for yield could see them buy SA bonds that are offloaded as they offer a yield (9%) that is higher than the 6% to 7% offered by emerging market peers Russia, India, and Indonesia.

The fact that SA’s bond market is exceptionally liquid and sophisticated, allowing investors to get out quickly, is an added bonus. For this fund manager, SA’s political and economic uncertainty is arguably immaterial, but an inflation-beating yield is first prize.

SA bonds held by foreigners

SA could have its own Brazil moment. Facing bad political leadership, self-inflicted economic challenges and a government that was unwilling to adopt structural reforms, Brazil was downgraded to junk (BB-plus) by S&P in 2015.

A wide selloff followed after the downgrade, Brazil’s 10-year bond yields spiked to more than 10% and the local currency tumbled by 35% in 2015.

Despite the country facing two years of negative GDP growth at the time, government debt of 70% to GDP and a fiscal deficit of 9%, foreigners still bought into Brazil’s bond market given attractive yields.

A triple junk downgrade might even see SA’s local-currency bonds still being held by Citigroup and Barclays but shifted to their emerging markets indexes that are ambivalent to credit ratings.

“You could get a foreign investment grade fund manager selling SA bonds to a sub-investment grade manager overseas and it doesn’t necessarily have to touch the rand or be sold back into SA,” said Glynos.

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