Junk Status: Not the End of the World For Bondholders

Key takeaways:

Deteriorating economic conditions and rising political risk have increased the probability that South Africa will receive its first “junk” credit rating in June.

South African bonds and other credit instruments have already substantially priced in the risk of a downgrade.

Based on previous cases of downgrades to junk in other countries, a likely scenario for bonds is another .50 percentage point increase in yields (including some volatility at the point of a downgrade announcement), followed by a 1 percentage point rally over the next 12 months. This means bond holders, from this point in time, should benefit over the medium term.

At over 9%, current 10-year government bond yields are attractive, offering a 3% real yield compared to 2.25% long-term fair value, even when considering the additional risks of a downgrade and higher inflation over the short term. This is why Prudential is moderately overweight bonds in our multi-asset class portfolios.  

Alarm bells have been ringing over South Africa’s ability to retain its investment-grade foreign currency credit rating for nearly two years now. However, it was only December 2015’s moves to downgrade the sovereign rating by Fitch to BBB- and to place it on negative outlook by Standard & Poor’s (S&P), followed by the shock dismissal of Finance Minister Nhlanhla Nene undermining the government’s fiscal credibility, that brought the issue to the forefront of public debate.

In March Moody’s placed South Africa on negative review, and there is widespread belief that its latest due-diligence will result in a one-notch downgrade in its rating, from Baa2 to Baa3. This would bring Moody’s in line with the other two main rating agencies and South Africa would then sit on the brink of a junk rating, requiring just one further downgrade to complete the process. The country successfully escaped junk status back in the year 2000.

Background

Thanks to the many headlines, the man-on-the-street is now well-acquainted with the issues that have brought the country to this point: slow growth is making it more difficult for the government to meet its revenue targets and to reduce its budget deficit; poorly run state-owned enterprises (SOEs) make ever-greater demands on the government’s balance sheet; low prices for our commodity exports and steep bills for high-tech imports and SOE capital equipment requirements make it difficult to reduce the trade deficit; and foreign investment inflows to pay for this deficit are dwindling. These are but a few of the issues the agencies are considering when assessing the credit worthiness of South Africa. 

Back in September 2014*, I argued that there was no imminent threat of a downgrade to junk or non-investment grade status for the country, given the well-defined and scheduled series of steps the ratings agencies had to follow to reach that level. Just as importantly, economic growth (one of the primary factors considered by the agencies) had not deteriorated to such an extent that the government could not achieve its longer-term budget deficit targets. 

Almost two years down the line, however, the agencies have nearly completed all the steps needed to reach junk status. With their ratings sitting just one notch above non-investment grade at BBB-, S&P and Fitch could lower them to junk at their next scheduled reviews in June. Their December reviews would provide another opportunity. 

Growth much slower than expected

Meanwhile, our pace of growth has slowed substantially more than expected: in 2014, the agencies were forecasting GDP growth of about 3.0% in 2015, a far cry from the 1.3% actually recorded. And no one would have imagined less than 1% growth in 2016 (Moody’s is now estimating a paltry 0.5%
for this year and 1.5% in 2017). Through 2020, the IMF is projecting disappointing GDP growth for South Africa, only just exceeding 2%. This makes it extremely difficult for Finance Minister Pravin Gordhan to achieve the deficit targets set out in the latest budget.

Rising inflationary pressures, largely absent in 2014, are also a cause for concern. Should the South African Reserve Bank (SARB) be forced to implement more interest rate hikes to curb the inflationary effects of a weaker rand and higher food and administered prices, the result would be a further drag on the economy and deterioration in government revenues, increasing the chances of a worsening budget deficit. As long as the path of interest rate rises remains slow and gradual, however, there is less of a chance that such a vicious circle could be created.  

Another consideration is that the government has implemented few pro-growth reforms that the agencies want to see, despite many proposals. These much-discussed initiatives have included limiting the duration of strikes, allowing secret union ballots, public-private partnerships, partial sales of SOEs, etc. Some concrete actions need to be taken to demonstrate the ANC’s determination to boost growth, despite certain costs to their political capital.

All of the above risk factors have increased the probability that South Africa will receive a junk rating from S&P and/or Fitch as soon as June. The timing of Moody’s next move is less certain, given that they are not governed by the same fixed timetable as the other two agencies. 

SA bond yields already reflecting a downgrade

By several measures, the local fixed income market has already built in a risk premium, anticipating and discounting a move to junk status. South Africa’s US dollar debt in the Emerging Markets Bond Index (EMBI) is considered more risky than lower-rated Russia and other similarly rated countries – it is trading at a premium of 4.10% over US Treasuries compared to Russia’s 2.74%. At the same time, the cost of insuring against a default by the South African government for five years is also higher than its peers, at 3.18% compared to 2.89% for Russia and 2.85% for Turkey.  

Looking at bonds, Graph 1 shows that investors are demanding yields of 9.3%-9.4% to hold 10-year South African government bonds, which is roughly equivalent to, or higher than, yields in countries like Turkey, India, Indonesia and Russia. This is also high compared to historic yield levels: back in January 2015, 10-year bonds were yielding around 7%, so there has been a rise of nearly 2.4 percentage points.

Similar downgrade cases show limited medium-term losses

Given this substantial increase in our bond yields over the past 15 months in anticipation of a downgrade, it is less likely that there will be a further huge spike in yields when the event actually occurs. In fact, an examination of the experience of other countries downgraded to junk status confirms this.

Graph 2 highlights how, in the cases we studied, bond yields rose an average of about 3 percentage points in the 12 months prior to the downgrade (shown by the dotted line, starting 12 months before the downgrade, and with the actual downgrade point at “0” on the horizontal axis), but then fell an average of 1 percentage point in the 12 months following the downgrade. And, those countries that lost the most in the run-up to the downgrade rallied the most after the fact.

Can South Africa expect a similar scenario?

South Africa already has built in an increase of 2.4 percentage points in yields, so compared to the average experience of about 3.0, from these current market levels it is reasonable to expect that our market could see another 0.5 percentage point rise in bond yields ahead of a downgrade. Even if the downgrade is fully priced in already, we would anticipate more weakness at the point of downgrade to junk as offshore investors not allowed to hold sub-investment grade assets would be forced to sell their offshore South African bond holdings. 

However, it is important to note that this “forced selling” will likely be limited, since South Africa’s inclusion in the World Government Bond Index depends on maintaining our local currency rating (rather than our foreign currency rating) at investment grade. This rating is not expected to fall to non-investment grade anytime soon: it was last affirmed at BBB+ by S&P (three notches above junk status), BBB by Fitch and Baa2 by Moody’s (both two notches above junk).

So after some short-term volatility following a downgrade, previous cases tell us that bonds are likely to rally over the subsequent year – by an average of 1 percentage point. Countries like Portugal and Hungary fully recouped their losses within 12 months or less.

Prudential is moderately overweight bonds

In our view, the yields of over 9% on long-dated SA government bonds offer compelling value over the medium term, even factoring in the risks of an impending downgrade and higher inflation over the short term. With long-term inflation in our view anchored at 6%, this translates into real yields of over 3%, significantly above our long-term fair value estimate of 2.25% for this asset class. No other asset classes currently look so attractive on a risk-adjusted, medium-term basis; consequently we are overweight these bonds in our multi-asset class portfolios like the Prudential Inflation Plus Fund, Prudential Balanced Fund and Prudential Enhanced Income Fund.

The market appears to be over pessimistic about the country’s short-term future, and this is shown by the very cheap pricing of bonds. The market is factoring in average 10-year inflation at 7.5% and at least three 25-basis point (bp) interest rate hikes over the next 12 months, implying that the SARB will lose control of inflation. By contrast, we believe in the National Treasury’s ability to reduce the budget deficit, as well as the SARB’s commitment to maintaining inflation within its 3%-6% target band over time.

It is also our view that local interest rates will rise at a gradual pace going forward – less quickly than the market expects. The SARB is cognisant of our weak growth outlook and will want to monitor the effects of the cumulative 225 bps of rate hikes they have implemented to date. Internationally, we see the US Federal Reserve stepping back from its tightening programme and a continuation of quantitative easing in Europe and Japan. 

Sticking to our successful investment process

While our bond positioning may seem “brave” amid the current gloomy environment, it is only par-for-the-course for us as long-term investors. It is at times like these – when sentiment becomes excessively pessimistic – that we believe consistently applying our rigorous risk and valuation metrics can deliver the best results over the medium term. Should bond yields rise further, we would likely buy even more bonds for our multi-asset class portfolios. Individual investors would also do well not to fall under the spell of market sentiment, but to stick to their long-term investment plans.  

*This article is an update to “Is Junk Status an Imminent Threat to South Africa?“ published in the Spring 2014 edition of Consider this.