In June or possibly later in December the rating agencies will review South Africa’s credit worthiness and decide whether or not our country retains its investment grade rating.
The best way to understand a credit rating review is to compare it to an individual’s credit rating. If a bank believes you are a good credit risk, they are more likely to lend you money and at a reasonable interest rate.
If a bank feels that your debt levels are too high and your future income earnings are at risk, it will consider you a higher risk client who may default on your debt repayments. The bank would then be less inclined to lend to you and if it did, it would be at a higher interest rate to offset that risk.
The catch-22 for the client is that at a time when they are already feeling financial pressure, they now face the prospect of more expensive debt repayments. The same applies to a country’s sovereign debt.
The South African government currently borrows offshore through the issuance of government bonds. Rating agencies such as Moody’s and Standard & Poor (S&P) assess the credit worthiness of those government bonds.
Investors use these agencies to obtain a view on whether a government or corporate bond, in which they are investing, is investment grade or “junk bond”.
Investment grade bonds have a “BBB” or higher credit rating when rated by S&P or a “Baa3” or higher when rated by Moody’s. South Africa is currently holding on to the minimum investment grade level which gives investors comfort that the government is likely to make payment on both capital or interest payments.
A bond reaches sub investment-grade status when it is graded lower than a certain level by ratings agencies. A “BB” or lower rating is junk status for Standard & Poor (S&P) while Ba and below is junk status for Moody’s.
A junk status means there is high default risk on the bond. This can be as a result of a poor economic growth outlook and political, social and policy instability and uncertainty. That is why they have a very high yield, or simply put, why the issuer has to pay very high interest rates.
Generally there has been a decline in the credit worthiness of many countries with only 53% of all rated sovereigns meeting the investment grade (“BBB”- or above). This is the lowest level it has ever been, nevertheless South Africa has fallen more significantly than most of our counterparts and a move to below investment grade would make South Africa one of the worst performing countries since 2008 with regard to the performance of sovereign credit ratings. It would also reverse the substantial gains made by the new government since the end of apartheid. It is only in 2001 that South Africa gained investment grade status through sound financial management of the government budget and strong economic growth.
How would it affect your investments?
It’s important to understand that this downgrade would only affect our offshore bonds issued in USD and not our local rand-denominated government bonds, which remain two notches above junk status.
We can, however, expect a knock-on affect as the investment appetite in our local bonds could be reduced and capital flows to the country could decline.
We need these flows to finance the current account deficit because South Africa’s savings rate is at the low end. Large current account deficits have a negative impact on the exchange rate, resulting in higher import inflation as imports become more expensive.
It’s also possible that if the demand for local bonds declines, the bond yields would rise further, which means that the capital value of the bonds would fall.
This would not only be bad news for bonds but also for listed property shares as their yields are directly correlated to the bond yields. As listed property yields rise, so the capital value would fall.
It is less likely to have a long term impact on the equity market which may fall initially on the news but should recover as equity prices are driven by economic growth and company earnings rather than bond yields.
Although this may seem like doom and gloom for investors, it is likely that the downgrade has already been priced into the market as most investors seem to believe that a downgrade is inevitable, if not in June then at least in December. At this stage we are not sure to what extent it has been priced in, but if the country is not downgraded, it would be very positive for all asset class prices. |
