R112 billion could be wiped as junk status looms for South Africa

Ratings agencies Moody’s and S&P Global will be announcing their rating decisions for South Africa on Friday evening, which could have massive implications for the country’s government bonds, should it go the way many expect.

Currently, both Moody’s and S&P have South Africa on a negative outlook, with the former keeping the country’s local and foreign currency debt one notch above junk, and the latter keeping local currency debt above junk, and foreign currency debt in junk.

Fitch, the other large global rating agency, has South Africa in full junk. Fitch does not publish its review dates, but its ratings are arguably less significant as its rating is not a determinant of a country’s bonds in the Citigroup World Government Bond Index (WGBI).

The WGBI is the most used global bond index for both indexation and benchmark purposes and requires at least one rating agency between S&P and Moody’s to assign an investment grade credit rating to the local currency government bonds for inclusion in the index.

Should this happen, over R100 billion will be wiped from the economy.

The current outlook

According to analysis by Ashburton Investments, following the delivery of the medium-term budget speech by Finance Minister Malusi Gigaba on 25 October 2017, all the major rating agencies expressed concern regarding the deteriorating finances of the South African government.

These concerns stemmed from the slippage in fiscal revenue and resultant increase in the forecast budget deficit.

“The lack of a concrete plan to remedy the situation was one of the primary differences between this MTBPS and those of other finance ministers, and that has greatly contributed to the slippage in the bond yields and exchange rates,” the group said.

“Although most market commentators expected a downgrade to the South African credit rating, most anticipated this to occur following the ANC elective conference in December 2017 and the delivery of the full budget in February 2018.

“However, the recent statements by the credit rating agencies have raised the probability of further rating downgrades occurring on Friday,” it said.

The announcements on Friday have four notable outcomes, Ashburton said.

• Neither Moody’s or S&P takes any further action on the South African credit rating;
• Moody’s downgrades the local currency and foreign currency international scale rating from Baa3 (BBB- S&P equivalent) to Ba1 (BB+ S&P equivalent), while S&P’s rating remains unchanged;
• S&P downgrades the local currency international scale rating from BBB- to BB+ while Moody’s rating remains unchanged; or
• S&P downgrades the local currency international scale rating from BBB- to BB+ and Moody’s downgrades the local currency international scale rating from Baa3 to Ba1.

“Our base case scenario is that the agencies will either place the rating on review for downgrade or pause until post February next year, making the double downgrade by both agencies a lower probability event. We do, however, expect a downgrade by both before June of next year unless we see significant alterations in policy and the local economic forecasts,” the group said.

For each of the above outcomes the market would react differently, it said.

What will happen to government bonds?

By far, the worst outcome would be if both S&P and Moody’s cut the local currency rating to sub-investment grade – South Africa would then fall out of the WGBI and the funds tracking this index as a benchmark would become forced sellers.

“The magnitude of this forced selling is difficult to determine, but could be as high as $8 billion (R112 billion at R14.00 exchange rate),” the group said.

“While we believe that most yield reaction of the downgrade to junk has already occurred, we would not be surprised if the benchmark R186 Government Bonds experiences a further sharp selloff to 9.85% or even higher over the short-term.

“Historically, yields have recovered in the weeks and months post a downgrade to junk status and it is likely that we would see a similar effect. What could hamper this, however, is the political and policy uncertainty that is likely to remain until the budget next year February,” it said.

A short-term relief rally of 25 basis points or so would, however, probably materialise if South Africa manages to retain its position in the WGBI post the ratings release on 24 November.

Over the medium-term, the primary factor determining where our yields settle will be the global backdrop and the risk on/off appetite.

“Given that South African bonds currently yield in excess of CPI +5%, we at Ashburton Investments remain fairly constructive on bonds for as long as global inflation remains under control and central banks globally taper their buying programs very gradually,” the group said.

Read: Not all economists are bleak about South Africa’s ‘junk’ economy