A sovereign downgrade: will SA’s crown topple?

On Friday, 25 November Fitch Ratings announced that the outlook attached to its BBB- ratings of SA foreign and local currency sovereign debt has moved from stable to negative, and warned that continued political instability could lead to the downgrade of the sovereign to sub-investment grade. The company expects the political risks facing the country to remain high at least until the ANC’s leadership election in December 2017. Moody’s kept the sovereign rating unchanged at Baa2, two levels above subinvestment grade, with a negative outlook.

All eyes are now on this Friday’s report

On the same day Standard & Poor’s Global Ratings (S&P) cut Eskom’s credit rating a further notch into subinvestment grade, increasing fears around S&P’s downgrading the sovereign to junk status. It cut Eskom’s long-term corporate credit rating from BB+ to BB, two steps below the investment threshold. S&P currently has the SA sovereign debt on the lowest investment level with a negative outlook and will publish its report on the state of South African debt on 2 December.

A downgrade has been priced in already

Says Frederick White, head of Balanced at Sanlam Investment Management, ‘The possibility of downgrades has been all over the news for much of this year and if it happens it certainly can’t be described as a surprise to anyone.’ White and his team believe the possibility of a downgrade, along with its consequences, has been priced into financial markets. Even if actual downgrades turn out to move the financial markets, such moves are likely to be temporary in nature.

Distinguish between speculation and investment

Experience with downgrades elsewhere in the world has shown the impact on financial markets to be most significant prior to the event, with normalisation the most likely reaction in markets post the event. South Africa seems to be following that same route, especially in the bond market where yield spreads relative to global bonds have expanded considerably over the last two years. To pre-empt negative moves that might occur (and that are not possible to forecast with any accuracy), can easily destroy value and amount to speculation rather than investing.

‘We hence don’t deem it appropriate to implement positions in our portfolios for possible adverse short-term moves, but rather elect to position our portfolios according to where there is value on offer’, says White. ‘Should any unexpected short-term movements materialise in the financial markets and lead to opportunities to buy assets at levels that are likely to lead to value-creation for our clients over the longer term, we’ll pursue those opportunities when they arise.’

A downgrade is likely but not certain

Mokgatla Madisha, head of Fixed Interest at Sanlam Investment Management, concurs that a rating downgrade has been well telegraphed and the markets have been pricing in a deterioration of SA credit quality for some time now. This does not mean that a downgrade is certain, particularly from S&P and Fitch. The outlook that Moody’s attached to its rating action on Friday is very important. The negative outlook increases the chance of an S&P downgrade in December.

Current valuations on bonds are attractive

Madisha says the 9% yields on South African bonds are very attractive compared to developed market yields of 2.3% in the US, 0.25% in Germany and 0.03% in Japan. Inflation is expected to peak in the fourth quarter of 2016 and return to within the SA Reserve Bank’s inflation target band of 3% to 6% by the second quarter of 2017. We also expect inflation to average around 5.7% in 2017. At current yields bonds would deliver real returns of about 3.3%, which is excellent. In comparison inflation-linked bonds are giving a 2% real return and cash will deliver real returns of about 1.3%.