The ins and outs of an SA sovereign credit ratings downgrade

17 June 2016

South Africa’s sovereign credit rating has been steadily downgraded over the last four years and the pace of the negative ratings trajectory looks set to continue.

Despite this trend there has been little evidence that effective efforts are being made to maintain the current rating within the investment grade band. The rating debate has intensified since December 2015 when not one, but two, South African ministers of finance were replaced in quick succession. This promptly sent the bond market and the rand into a tailspin. Since then, the extent of damage control has been prolific with Finance Minister Pravin Gordhan stating that the government must “do whatever is necessary to avoid a cut to sub-investment grade”. Unfortunately, a lack of bold remedy in February’s Budget presentation saw the year start with the seemingly inevitable hanging over South Africa’s head namely a downgrade to BB+ by at least one rating agency[CB1] . Many investors however still remain  unsure of the full implications of such a move or, indeed, the role of ratings agencies as a whole.

Sovereign ratings: The basics
A credit rating is an opinion about the relative creditworthiness of an issuer, or a country. This is determined through an assessment of the sovereign’s ability and willingness to honor its existing and future obligations in full and on time. There is a wide variety of credit ratings that are produced by a number of international and local credit rating agencies – and while methodologies across rating agencies are broadly similar, the finer nuances of these methods, coupled with the different types of ratings that these agencies produce often make them hard to interpret.

Long and short-term ratings: A long-term rating is applicable to obligations with a term to maturity of more than twelve months, while a short-term rating reflects the probability of default over a period of up to a year.

Credit outlook: Outlooks are assigned to long-term ratings and indicates the expectation of the direction of a ratings move over the next twelve to eighteen months. The outlook can be negative, positive or stable (no change expected).

Foreign currency and local currency ratings: A country’s ability to repay its obligations in its local currency could be stronger than its ability to repay in foreign currency. Historically, default rates on local currency sovereign debt has been lower than on foreign currency denominated sovereign debt. The extent of the differentiation between the foreign and local currency rating depends on the depth of the local-currency capital markets and the degree of independence of monetary policy but is rarely more than two rating notches.

Rating reviews: Formal ratings reviews are generally performed annually, but most international ratings agencies will conduct bi-annual assessments (mid-year reviews) as well. 

There are currently three global rating agencies that rate the government of South Africa: Moody’s Investor Services (“Moody’s”), Standard & Poors (“S&P”) and Fitch Ratings (“Fitch”). The South African government foreign currency and local currency ratings by these agencies are indicated below:

Table 1: South African sovereign credit ratings

Credit Rating Agency	Date	Action	Local currency	Foreign currency	Outlook
Fitch	4 December 2015	Downgrade	BBB	BBB-	Stable
Moody’s	15 December 2015	Negative outlook	Baa2	Baa2	Negative
	8 March 2016	Review for downgrade	Baa2	Baa2	Negative
S&P	4 December 2015	Negative outlook	BBB+	BBB-	Negative

Do ratings matter?
Sovereign credit ratings are an indicator of the risk level associated with the investment environment of a country and are used to determine the risk premium payable on debt instruments issued by the country. A downgrade to investment grade should always be taken seriously as on average it takes a country seven-and-a-half years to regain its investment grade rating, if at all, once it has been downgraded to sub-investment grade. 

Unfortunately, a lack of bold remedy in February’s Budget presentation saw the year start with the seemingly inevitable hanging over South Africa’s head namely a downgrade to BB+ by at least one rating agency[CB1]. 

What happens next?
Our base case is that S&P will downgrade South Africa’s foreign currency rating to sub investment grade in December 2016

What is the likely impact on of a downgrade to sub-investment grade on the local markets
While the consequences of a ratings downgrade mean on-going negative sentiment from foreign investors, a still elevated cost of capital and continued high levels of rand volatility we think this has largely been priced into bond markets.  South Africa’s fundamental rating indicators appear to be in line with sub-investment grade averages and market indicators which suggest that Investors are already regarding South Africa as a sub-investment grade country.  

The specific impact on bond yields at the time of a downgrade will therefore probably be more influenced by the outlook for interest rates in the global economy, especially the United States and the interest rate trajectory there.

Our sense is that Local government bond yields appear to have largely priced in a downgrade and are fairly priced. Indeed longer term bond yields in excess of 9.0% appear to offer relatively attractive real yields given our view that longer term inflation will be constrained by a sub- par economic environment.

Our bond and credit portfolios are positioned to look through this short-term volatility and take advantage of compelling medium-term valuations in bonds. During this time of uncertainty, our approach is to stick to the basics: select counterparties carefully, ensure we are well positioned to execute as opportunities arise, and ensure that each of our assets is priced for value through the cycle.