SA post downgrade – has the sell-off stabilised?

By Mokgatla Madisha, head of Fixed Interest at Sanlam Investment Management

The downgrade by Standard & Poor’s (S&P) of SA’s local currency by one notch to (BBB-) and it’s foreign currency debt to (BB+), one level below investment grade, has long been anticipated by markets, and was largely priced in by the time of the announcement on Monday 3 April.

According to S&P a BB rated borrower ‘faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions which could lead to the obligor’s inadequate capacity to meet its financial commitments.’

South Africa has been experiencing slow economic growth and massive increases in debt over the last eight years due to low commodity prices and high spending levels relative to income growth. As a result its capacity to meet future financial obligations is no longer deemed adequate. Rating agencies have been warning about the risk to the fiscus posed by the poor financial performance of our state owned enterprises (SOEs).

South Africa narrowly escaped a downgrade last year because government, business and organised labour committed themselves to reforms that would make the economy more resilient. It is now S&P’s perception that those efforts have stalled.

What has been the impact of recent announcements on the markets?

A weaker rand is not necessarily inflationary

The rand has lost about 10% since Minister Gordhan was recalled from his oversees trip and bond yields have risen about 90bps. A 10% weakening of the rand, if sustained, will result in inflation going up by about 0.70%. However, at current levels of about R13.90/USD the rand is still 5% stronger than last year’s average level of R14.70/USD. The current level of the rand is therefore not inflationary.

Bond markets have priced in the downgrade

The 90bps increase in yields over the last week has reduced bond portfolio values by about 6.6%. We have seen very little trading in corporate bonds but a number of auctions were postponed as a result of the volatility of the last week. We expect even more pressure on SOE spreads and possibly on bank bonds too.

A rating downgrade usually drives more selling as bonds no longer fall within mandates. South Africa is still rated investment grade (IG) on its local currency debt and our view is that we are not likely to see much more selling as a result of the S&P announcement. South Africa’s five-year dollar credit default swap (CDS) was already priced at the same level as Brazil, which is rated BB, around 225bps. Furthermore, Russia and Croatia, which are rated BB, are trading at 167bps and 181bps respectively. On a relative basis SA debt has been priced for the downgrade.

The negative outlook is worrying

S&P retained a negative outlook on the rating, suggesting that they see scope for further action if there are no corrective actions taken. How policymakers respond to the downgrade is going to be crucial. If South Africa is to regain IG status, tough decisions are needed. Faster fiscal consolidation is imperative and the Budget needs to be more resilient, which means expenditure must be more aligned with revenue growth.

How are our portfolios positioned?

Sanlam Investment Management (SIM) remains overweight SA long bonds, as reflected in our flagship multi asset fund, the SIM Balanced Fund. The real yield on offer remains attractive relative to that of other developed and emerging markets. And, yes, part of the high yield on offer can be ascribed to the political risk South Africa has been facing.

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