On Friday, 27 March 2020 Moody’s (one of the three major credit rating agencies) downgraded South Africa’s sovereign credit rating to sub-investment grade while maintaining a negative outlook. Fitch and S&P (the other two major agencies) both downgraded South Africa (SA) to sub-investment grade in 2017.
Moody’s highlighted the following primary drivers in coming to their decision:
- Structural economic bottlenecks that limit gross domestic product (GDP) growth potential and employment creation
- Deteriorating public finances and unfavourable debt dynamics
- The acute financial stress state-owned enterprises (SOEs) are under, particularly Eskom.
- Uncertainty around structural reforms and implementation risk
While the downgrade had largely been priced in by financial markets, the timing thereof could not have been worse; it came amid a wave of global risk aversion, further currency weakness and higher bond yields.
The yields on SA bonds reflect the rate at which the government can borrow money. Generally speaking, a downgrade would be associated with a higher risk profile and result in a higher yield and consequently more expensive borrowing for the sovereign.
Additionally, the rules for certain passive indices and institutional mandates stipulate that only investment-grade debt may be held and there may be some forced selling as a result of this change in rating for South Africa.
Given the current market turmoil related to Coronavirus (COVID-19), markets have been inherently more volatile, and liquidity has been constrained. This event could exacerbate this issue in the local bond market.
In financial markets the news itself is often overshadowed by the extent to which the event was expected and consequently priced in already (the local bond market is down approximately 12% year-to-date). The current yields on SA bonds already compare with those of other sub-investment grade countries around the world, and as such this event does seem to be largely reflected by current prices.
Given recent market turmoil, the usual quarterly rebalancing of passive indices has been delayed by a month, which should alleviate any immediate selling pressure on SA bonds. The current level of SA bond yields is very attractive given the low rate environment globally and yields a significant margin over inflation (approximately SA CPI + 7% for 10-year bonds). While the downgrade is negative, there may be investors who still find appeal in the relatively high-yielding SA debt.
The primary portfolio impact within fixed income will be through lower valuations and higher yields on South Africa’s bonds. As such funds that either hold bonds or are dedicated bond funds will feel the most direct impact. Funds that do not participate in the bond market will largely escape short term downgrade volatility.
Below is a view per portfolio:
- The Ashburton Money Fund will not be influenced by the downgrade as the fund does not trade in bonds or duration. There is also unlikely to be any credit impact.
- The Ashburton Stable Income Fund will likewise not be influenced in the short term as it does no duration trading. In the medium term, credit is likely to become riskier, but the credit process and fund limits will mitigate most of the risk.
- Ashburton SA Income Fund does trade in bonds, but as can be seen from the bond moves subsequent to the downgrade, most of the rise in yield will have occurred by the time the announcement is made. Bonds are likely to remain somewhat volatile, but investors should be compensated by the higher than normal yields that are currently available in the market.
- The Ashburton Bond Fund will have been very hard hit by the move in bonds, but the downgrade does provide an opportunity to increase duration and yields for a longer-term investor. With yields in excess of 12%, bonds look very attractive at the moment.
- Ashburton Diversified Income Fund has likewise been hit hard by the downgrade news, but it will also benefit from these high yields going forward.
In summary, the downgrade has certainly added to the flurry of recent negative news. However, the event itself is unlikely to surprise the market – and there are many mitigating factors that may result in the downgrade being met with mixed reactions from market participants.
The focus now shifts to government’s ability to effectively manage its debt profile and implement structural reforms. Clients do not need to be concerned as their portfolios remain well diversified and appropriately positioned for the current environment. The investment team continues to work throughout the current turmoil, making use of technology to meet more frequently than in normal circumstances; thereby ensuring that our fiduciary duty as stewards of client capital is discharged with diligence and due consideration.
Asset Allocation Team
Head: Fixed Income Portfolio Management