Luigi Marinus, Portfolio Manager at PPS Investments
The last of the three global ratings agencies, Moody’s, lowered South Africa’s sovereign credit rating to sub-investment grade late in March, and its outlook remains negative.
South Africa now has a sub-investment grade rating from all three major international rating agencies, as S&P and Fitch downgraded SA’s credit rating in 2017.
Our view was that the probability of a downgrade remained high and it was therefore unsurprising when Moody’s finally downgraded SA, in light of the weak fiscal backdrop and challenges to economic growth.
The downgrade followed a sharp increase in bond yields in emerging markets and South Africa, as markets discounted the effect of the world’s inability to contain the spread of COVID-19 resulting in economies effectively grinding to a halt. As a result, at the time of the downgrade, South African bond yields had already increased by more than 2% virtually across the yield curve and the direct effect of the downgrade was largely contained as markets had already reacted.
Downgraded – now what?
The subsequent impact of the downgrade will be South Africa’s exit from the FTSE World Government Bond Index (WGBI), which requires at least one investment-grade rating from the credit ratings agencies.
South African bonds will be excluded from the index when it rebalances at the end of April and global fund managers will be required to sell their South African bonds if they hold investment-grade mandates for clients. The resultant outflows will increase the supply of South African bonds but the impact on yields will largely be priced in as the market anticipates the exit.
Impact on investors
- Possible tax impact
The longer-term effects of a downgrade are possibly more difficult to overcome, especially for a country with a material budget deficit. A budget deficit relies on the ability of a government to borrow in the bond market. While demand for South African government paper has not been a concern, the level at which that debt will need to be serviced at has increased. As mentioned by the finance minister in South Africa’s most recent budget speech, one of the major concerns was the current interest burden on the state, and that a downgrade would increase this burden. This raises questions regarding other ways in which the fiscus can raise revenues, including possibly relooking at income tax rates and VAT.
- Exchange rate
Another direct impact is the effect on a country’s exchange rate. A downgrade is affirmation that a country’s ability to service its debt has reduced and therefore the value of its currency is likely to depreciate. Like most market movements this depreciation is normally overdone in the short-term, but resets in the longer term to a level weaker than before the downgrade. The effect of a weaker currency is more expensive imports and an eventual increase in inflation.
How the downgrade can present an opportunity
There is no doubt that the COVID-19 crisis together with the ratings downgrade has resulted in South African assets looking even more attractive on valuation grounds. This does not mean that investment risk can be ignored, simply because an asset looks cheap.
Even though a rating downgrade primarily affects the yield on bonds and consequently portfolios with a large bond holding, the increase in yields above inflation provides a significant margin of safety. Nominal government bonds with a 10-year maturity or longer are offering yields in excess of 10% and 11%. Similarly, inflation-linked bonds are offering a real return of greater than 5% (inflation for South Africa was averaging 4.6% in February, implying that the yield on inflation-linked bonds was above 9%).
Even though domestic equities look attractive, the certainty of the real return from bonds is difficult to compete with. In addition, the South African Reserve Bank (SARB) has already lowered the short-term lending rate by 200 basis points in the last month and has put steps in place to ensure liquidity in the bond market. Monetary stimulus is positive for the bond market.
As a result, our exposure to domestic bonds has been increased to a maximum overweight across portfolios, while the domestic equity exposure has been reduced by one notch from neutral to underweight (the global equity allocation across PPS portfolios remains at overweight, resulting in a total equity exposure at neutral). COVID-19, and the ratings downgrade in part, has resulted in sharp declines in global and local markets but has also provided a long-term opportunity to lock in a significant real yield for many years to come.
Invest with long-term view in mind
Market volatility and severe declines can make you feel uncomfortable, and understandably so. This is compounded by the fact that it comes during a period when more than one ‘Black Swan’ event has transpired (COVID-19 and the oil price shock). These will inevitably arise from time to time, and we recommend that you remain calmly committed to your long-term investment objectives, and avoid making any rash decisions due to the negative news flow.
A sensibly diversified portfolio ensures that as an investor, you are not overly exposed to any particular outcome, and that different components will perform well during various market cycles.
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