The inevitable Moody’s Investors Service downgrade – which will strip South Africa of its last investment-grade credit rating next year – will not be the cataclysmic event that many expect, as foreign investors have already sold off a large chunk of their holdings of government bonds, and market prices now reflect that scenario.
For the past year, anticipation of the downgrade and uncertainty over when it would happen has kept investors and businesses on edge and sparked speculation of massive, sudden outflows from the bond market which would hit the rand, increase inflation and lead to higher interest rates.
An alarming deterioration in public finances flagged by Treasury in its medium-term budget policy statement in October 2019 cemented those concerns and prompted both Moody’s and Standard & Poor’s to slap a negative outlook on their credit ratings for SA.
But the kneejerk sell-off in bonds which will follow the event is unlikely to be severe as the difference between the yield on SA’s rand-denominated bonds and domestic inflation – known as the real yield – will remain large enough to keep them attractive to many local and foreign investors.
“We have to be very careful that we don’t go and catastrophise this whole thing into something that it might not be,” says George Glynos, managing director at Econometrix Treasury Management.
“The debate around this issue has been far too simplistic and people are thinking about this in a very superficial way.
I don’t think they have taken enough time to apply their minds and really understand the mechanics of how markets work.”
The main concern over a Moody’s downgrade is that it will tip SA out of Citigroup’s World Government Bond Index, forcing passive managers who track the index and others who only hold investment-grade bonds to sell large amounts of local debt.
Kuben Naidoo, Reserve Bank deputy governor, said on 27 November that $5bn to $8bn of SA government bonds could be at risk.
But there is plenty of evidence to show that most of the response to the anticipated event may have already happened.
According to data from the JSE, foreigners sold a net $1.3bn of SA bonds between September 2018 and September 2019, while Treasury has pointed out that in October, non-residents held 37% of the government’s rand-denominated debt – down from a peak of 43% in March 2018.
And, during 2019, SA bonds underperformed those of other emerging markets, which were supported by falling US interest rates, improving appetite for riskier, higher-yielding investments.
As a result, SA bonds now offer the highest real yield of all major emerging markets, says John Orford, portfolio manager at Old Mutual Investment Group.
The yield on the benchmark 10-year bond stood at 9.25% on 3 December, which put the real yield at 5.5% after taking account of the latest inflation rate of 3.7%.
The real yield on the comparable bond in Brazil – which has been sub-investment grade since 2016 – is hovering at about 4%, while those of Russia and Indonesia are even lower (also see p.16).
In a world where yields on debt and equity are currently very low, this means the valuation of SA bonds remains attractive, particularly as there is little risk at present of a debt default or a spike in inflation, Orford says.
Other investment managers agree.
“Who is to say that there isn’t enough demand to soak up the bonds which are sold off after a Moody’s downgrade?
The other thing is that people are assuming they will all hit the market at the same time,” Glynos says.
“You may even get a counter-intuitive market reaction where, by the end of that week, you will find the market even stronger.”
Peter Attard Montalto, economist at Intellidex, believes that a likely $5bn to $7bn sell-off is “absorbable” and, although bond yields will spike, they are likely to settle at about 0.25 percentage points higher than before the event.
“It’s a negative for the economy and for the fiscal space, but it’s not a cliff-edge incident,” he says.
He warns, however, that the impact on corporate sentiment is more worrying than for financial markets as it’s being seen as a bellwether within the business community.
In the longer term, prospects for SA’s bonds are much more worrying.
With the debt-to-GDP ratio now projected to soar to around 80% over the next few years, from less than 60% at present, more downgrades are likely unless the government manages to get its fiscal house in order, analysts warn.
News that growth contracted by 0.6% in the third quarter of the year suggests that the economy may not have expanded at all in 2019, which will make it even harder to generate the tax revenue needed to improve SA’s debt outlook.
Capital Markets economist John Ashbourne believes the root cause of SA’s debt problem is weak economic growth seen since the recession in 2009.
“Ministers have, quite simply, budgeted for the economy which they want rather than what they have,” he said in a recent research note.
Mariam Isa is a freelance journalist who came to SA in 2000 as chief financial correspondent for Reuters news agency after working in the Middle East, the UK and Sweden, covering topics ranging from war to oil, as well as politics and economics. She joined Business Day as economics editor in 2007 and left in 2014 to write on a wider range of subjects for several publications in SA and in the UK.