What If SA Debt Is Downgraded To Junk?

According to our investment economist, Arthur Kamp, the South African economy is in a downswing (at the very least a growth recession) and is experiencing its slowest income growth since the past recession. This, among other factors, places SA at risk of a credit downgrade. What will happen to your portfolio should rating agencies act on their concerns and downgrade SA debt to sub-investment grade?

Arthur says, ‘One key concern of rating agencies is the lack of GDP growth to support projected government spending.’ But how likely are we to see our sovereign debt downgraded to sub-investment (‘junk’) grade? ‘Essentially, this is a close call and unknowable,’ says Arthur.

A sovereign downgrade is generally negative for all asset classes – bond, property and equity prices – but how much of the bad news is already priced into markets?

Head of Fixed Interest at Sanlam Investment Management (SIM), Chris Hamman, explains that it is not as simple as predicting that an adverse event, such as a debt downgrade, will be followed by a fall in market prices. ‘If South Africa’s credit rating is downgraded, it stands to reason that investors may be less confident in the country’s ability to meet claims on its economic resources. Financial markets may therefore react negatively to a credit downgrade. However, it appears that a credit downgrade is widely anticipated, in which case it may already be discounted. It is therefore not obvious that a credit downgrade will result in an adverse reaction in the market, unless the downgrade is more substantial than currently expected.’

Chris reminds investors that bonds have already sold off significantly during December, with longer dated bonds trading almost 200 points weaker from the end of September to the worst point in December 2015. The sell-off was due to the surprise decision to replace Finance Minister Nhlanhla Nene with a mostly unknown David van Rooyen. South African assets subsequently sold off sharply – the rand weakened, equities sold off and bond yields moved up sharply. Already at the start of December, prior to these events unfolding, S&P had revised their outlook attached to their BBB- rating on South Africa to negative from stable, one notch above junk status.

Gerhard Cruywagen, chief investment officer at SIM, echoes Chris’s view. ‘Over the next year or two, there is the possibility of a downgrade of SA’s credit rating to sub-investment grade. Bond investors are well aware of this and their fears are more than likely reflected in the current bond prices.’

SIM currently views SA bonds as attractively priced relative to the real returns available on bonds in other developing and developed markets and SIM has therefore increased its overweight exposure to SA bonds this year.