Another credit downgrade: buying opportunity or cause for concern?

As an emerging economy, South Africa is heavily dependent on funding from foreigners and local institutions to invest in the infrastructure of the country and fund the nation’s budget shortfall. As a country we only received investment grade status in the year 2000, giving us access to much needed affordable loans from global investors. It’s important that we keep this credit rating healthy. But our country is facing challenges and investors and credit rating agencies are increasingly concerned about our ability to bring our debt under control.

Already in April 2017 Standard & Poor’s (S&P) downgraded our foreign debt rating to non-investment grade (junk), but up to now it has left our local currency (rand) debt at one notch above investment grade. Also in April, importantly, Fitch was the first rating agency to downgrade our local and foreign currency debt to junk.

Then on Friday, 24 November at 11pm S&P announced that SA local currency debt is now also rated as non-investment grade, stating the downgrade ‘reflects our opinion of further deterioration of South Africa’s economic outlook and its public finances… Economic decisions in recent years have largely focused on the distribution – rather than the growth of – national income. As a consequence, South Africa’s economy has stagnated and external competitiveness has eroded.’

Having our local currency debt downgraded to junk by two rating agencies brings SA bonds closer to being excluded from some international bond portfolios, but in truth this announcement has long been anticipated by markets. On the same day S&P lowered SA’s foreign currency debt to ‘BB’ from ‘BB+’ and Moody’s placed the senior unsecured bond ratings of the government of South Africa on review for downgrade.

The impact on SA bonds

We’ve already seen bond prices fall shortly after Minister Gigaba’s Medium-Term Budget Policy Statement (MTBPS) in October, which provided not much of a plan in terms of how we are going to reduce our debt as a nation and little comfort for credit rating agencies. The benchmark 10-year government bond yield spiked from 8.83 on 24 October to 9.55 on its worst subsequent days. At close of trade on 24 November the yield on the 10-year government bond stood at 9.335. There was less room for bond yields to spike further after Friday’s downgrade announcement; a lot of the damage had already been done shortly after the MTBPS.

‘How well bonds perform from here on in real terms (after inflation) will, to a large extent, depend on the policy response from government and we therefore keenly await the delivery of the National Budget in February 2018,’ says head of Fixed Interest, Mokgatla Madisha. ‘Should we eventually be excluded from some international bond indices, there will be some capital flight, but – on a positive note – these could create buying opportunities for Sanlam Investment Management (SIM).’

Our stock market has shown resilience

As in April, the Johannesburg Stock Exchange (JSE) has not shown a dramatic response to the downgrade. This could be because almost 60% of the income earned by companies listed on the Johannesburg Stock Exchange today is from offshore sources; our stock market has therefore become less reliant on the fate of the local economy. Taking a longer-term perspective, the JSE has generously outperformed inflation over the past decades. Our market has withstood credit downgrades, political and economic isolation, and worse phases of economic turmoil.

SIM has a process to manage money while facing risks like the recent downgrade

It’s in times like these that having a strong philosophy and process shows its mettle. Sanlam Investment Management (SIM) is first and foremost a value-orientated investment manager. This means that we always buy assets with a ‘margin of safety’ in the price. In addition, we have various strategies in place to mitigate risk and protect your client’s investment against severe market movements and we are disciplined in how we apply our investment process.

Further, SIM manages well diversified portfolios and it is unlikely that all assets in a portfolio will see their prices fall at the same time. Certain portfolios also have derivative protection built in to prevent large capital losses in portfolios.

When risk increases, we require a higher potential return from assets

We consider all the various risks when deciding which assets to buy on behalf of our clients. We make sure that the potential return from these assets are well matched to the risk being taken. In the light of our country’s escalating budget challenges, we now require a higher real return from SA bonds due to an increase in risk. We will adjust our purchases of bonds for client portfolios accordingly to make sure clients are being compensated for risk taken.

You play an important role in protecting and growing your clients’ wealth

It’s been proven that more money has been lost by investors switching out of portfolios than by the markets themselves when asset prices fall. This is because more often than not investors sell out of a portfolio at the worst time and then miss out on the subsequent recovery in asset prices by staying in cash for too long.

Keeping a cool head is essential for successful investing. While it may be tempting for your clients to run to cash for safety, the best investments tend to be made when the market is on ‘sale’. As financial adviser one of your most important roles is to remind your clients to take the long-term view and invest when others are losing their heads.