It has been more than two years since Fitch Ratings downgraded South Africa’s foreign and local currency bonds to sub-investment grade in April 2017. Just days earlier, S&P Global had done the same for South Africa’s foreign currency credit rating.
The third of the big agencies, Moody’s, also downgraded the country’s rating by one notch around the same time, although it kept it above investment grade. Ever since, investors have been waiting for Moody’s to make its next move.
At first, there was a high level of angst about this looming final downgrade, which would see South Africa fall out of the Citigroup World Government Bond Index (WGBI). Estimates are that this would lead to foreigners selling around R100 billion of local bonds.
Twenty six months later, however, Moody’s has yet to act. It has skipped making a decision a number of times, granting what many analysts see as reprieves from what is ultimately unavoidable.
“None of us are under any illusion that South Africa is an investment grade economy,” the head of fixed interest at Coronation Fund Managers, Nishan Maharaj, told the Glacier Investment Summit in Stellenbosch last week. “I think it is inevitable, given the current state of affairs, that South Africa will be downgraded to sub-investment grade.”
Everyone knows it’s coming
This might explain why a lot of concern abound the downgrade has dissipated over time. Even if it hasn’t actually happened, it’s accepted that it will. Having had a chance to scrutinise the likely impact, analysts have also become more sanguine about how the market will react.
“South Africa has the sixth most liquid bond market in the world,” Maharaj pointed out. “It turns over easily R30 billion to R40 billion in a day. So R90 billion to R120 billion in outflows could easily be absorbed in four to five days.”
Most analysts have also continually reminded investors that the downgrade is priced in. This is not something that will shock the market if everybody knows it’s coming.
However, the generosity of spirit that Moody’s has displayed has meant that this argument hasn’t perhaps been continually scrutinised as much as it should. Two years ago, the yield on 10-year government bonds was over 9%. It is now just above 8%. Is the downgrade still priced in even if the yield has come down so much?
How much is enough?
As the chart below shows, the current yield is below its five-year average. It is also significantly lower than its recent peaks of 9.37% in October last year, and 9.32% towards the end of 2017. Yields have only been lower than current levels once, and very briefly, since 2015.
This is important, because it raises the question of how much risk is really priced in.
“For us it’s very important to understand what is in the price,” Erik Nel, the chief investment officer at Terebinth Capital, told the Glacier Investment event. “And it’s very important to understand what the global backdrop looks like before you answer that question.”
There will be a once-off risk event when the downgrade happens.
The market will have to react to the forced selling of a large quantity of government bonds. The question, really, is how big that reaction will be.
“If we get closer to a downgrade and the rand is at 15 to the dollar and bond yields are 50 points higher, I’m more comfortable with the risk of a downgrade,” Nel said. “But if bond yields are where they are currently trading and the rand is below 14, then I’m quite nervous.”
It’s worth noting that yields have come down in many places across the world. Brazil, which has a credit rating below South Africa’s, has 10-year government bonds currently yielding 7.3%. Bonds in Russia, which is rated just above investment grade by all three agencies, are yielding 7.4%.
Against these peers, therefore, South Africa’s bond yield is still pricing in a margin of safety. The question is how much is enough?