How to sur­vive a sov­er­eign down­grade

There’s a mad scurry to get our eco­nomic house in or­der and prove to the rat­ings agency that we’re wor­thy of our in­vest­ment-grade credit rat­ing. As Stephen Gun­nion re­ports, even if we join Brazil in the junk bracket, not much may change for bond in­vestors

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Alot of fuss about noth­ing? Not en­tirely, but in­vestors may be over­play­ing the ef­fect a down­grade of SA’s for­eign cur­rency debt would have on the mar­ket — and in­vest­ment flows. Bond yields have al­ready risen sharply, pric­ing in more bad news. But af­ter re­gain­ing some com­po­sure af­ter De­cem­ber’s drub­bing when Nh­lanhla Nene was turfed un­cer­e­mo­ni­ously from Pres­i­dent Ja­cob Zuma’s cab­i­net, re­cent gains could re­verse if a down­grade does come through.

June is the month to watch, with Stan­dard & Poor’s and Fitch both due to re­view the coun­try’s credit rat­ings. Moody’s, which put SA on re­view for a down­grade on March 8, has 90 days to make that de­ci­sion. S&P is the one the mar­ket is most wor­ried about; it rates SA’s for­eign-cur­rency debt at BBB-, with a neg­a­tive out­look. Next stop is junk.

The “poster child” for SA’s un­cer­tain eco­nomic out­look is the po­ten­tial for a down­grade of the coun­try’s credit rat­ing to junk, says Shalin Bhag­wan, head of fixed in­come at Ash­bur­ton In­vest­ments. This is fu­elling in­vestor con­cern about their bond hold­ings. Some in­vestors are eval­u­at­ing strate­gies for hedg­ing their bond port­fo­lios against a loss in value from a down­grade.

“In our view, SA bonds have al­ready ex­pe­ri­enced a sell-off and much of the bad news from a sov­er­eign down­grade is al­ready priced in,” says Bhag­wan. “While in­vestors are ex­press­ing their con­cern about a bond mar­ket sell-off by link­ing this to a sov­er­eign down­grade, their con­cern is re­ally one of a sharp and un­ex­pected in­crease in SA bond yields from cur­rent lev­els. We do not rule out such an event, es­pe­cially given the cur­rent un­cer­tain en­vi­ron­ment.”

Whether a down­grade is fully priced into SA bond yields or not, An­drew Can­ter, chief in­vest­ment of­fi­cer at Fu­ture­growth As­set Man­age­ment, be­lieves it’s com­ing as the rat­ings agen­cies catch up with the mar­kets. Though prices have re­cov­ered as dovish com­ments from the US Fed­eral Re­serve boosted buy­ing of riskier as­sets, buoy­ing the bench­mark R186 bond 100 ba­sis points be­low the 10.4% it reached on De­cem­ber 11, the mar­ket is priced at sub-in­vest­ment grade.

“Rat­ings agen­cies tend to be a lag­ging in­di­ca­tor. You ex­pect the mar­ket to pre­cede them in their pric­ing and that was what De­cem­ber was about — pric­ing in that risk,” says Fu­ture­growth quan­ti­ta­tive an­a­lyst Rhandzo Mukansi. “If you look at credit de­fault swaps (in­sur­ance that in­vestors buy against the risk of a de­fault), SA is priced like a BB+ (sub-in­vest­ment grade) credit al­ready, like Brazil.”

Bar­clays Africa in­ter­est rate strate­gist Michael Keenan says more weak­ness is likely to follow the ac­tual down­grade. Spreads on credit de­fault swaps have widened, but are still tighter than those of Brazil. “Brazil is al­ready re­flect­ing a higher risk pre­mium than SA, so a down­grade is not fully priced in just yet,” Keenan says. “We would ex­pect more weak­ness in bonds and widen­ing of spreads if we get down­graded.”

While some bond in­vestors who are man­dated to buy only in­vest­ment-grade debt may al­ready have headed for the exit, Keenan says many in­vestors are pas­sive and will be able to sell their hold­ings only if the coun­try is down­graded to junk.

How­ever, it may not be that easy to fall into the junk cat­e­gory. It re­quires two of the three large agen­cies that rate the coun­try’s debt to clas­sify it as such. While Fitch rates SA the same as S&P, it has a stable out­look. Moody’s rat­ing is one level higher.

“If Moody’s had to down­grade us, that would only bring it in line with the others,” Keenan says. “It is pos­si­ble for it to hap­pen this year, but it would re­quire a con­tin­ued down­grade and that might be a bridge too far.”

Many of the pas­sive in­vestors in SA debt track in­dices such as Cit­i­group’s world govern­ment

bond index (WGBI), to which the coun­try was ad­mit­ted in 2012, and Bar­clays’ global ag­gre­gate bond index. But they in­clude mostly lo­cal-cur­rency govern­ment bonds. With S&P rat­ing our lo­cal cur­rency debt two notches above dol­lar debt, its rat­ings would have to be cut by three notches or more be­fore it be­came junk.

“That prob­a­bly buys us time,” Keenan says. “[Also,] the ma­jor­ity of the for­eign hold­ers of SA bonds are man­dated to in­vest in emerg­ing-mar­ket in­dices and these don’t take our rat­ings into ac­count.” Keenan es­ti­mates that of the roughly R450bn of our bonds that for­eign­ers own, more than half of that money would be ag­nos­tic to any rat­ings move. It wouldn’t re­quire an au­to­matic sale. Only the in­vestors that track the WGBI and global ag­gre­gate index would be af­fected and he reck­ons that’s less than a third of to­tal for­eign bond own­er­ship.

Fu­ture­growth’s Can­ter agrees a big dis­tinc­tion has to be made between dol­lar-de­nom­i­nated debt and lo­cal-cur­rency debt. While the former is pre­car­i­ously bal­anced between in­vest­ment grade and junk, the lat­ter is still sev­eral notches away. “When we were in­cluded in the WGBI, that was on our lo­cal-cur­rency debt,” he says. “A down­grade doesn’t nec­es­sar­ily trig­ger a sell-off.”

Mukansi says as long as ei­ther Moody’s or S&P main­tains our lo­cal debt on an in­vest­ment-grade rat­ing, we should re­main in the index. That will help se­cure the close to half a tril­lion rand of rand-de­nom­i­nated bonds held by for­eign in­vestors — 32% of govern­ment’s out­stand­ing rand debt. That com­pares with lo­cal bank hold­ings of about 17%, in­sur­ers with 8%, pen­sion funds at 31% and re­tail in­vestors in­cluded in the re­main­ing 11%.

Nev­er­the­less, if the coun­try is down­graded, Can­ter agrees that sen­ti­ment will be af­fected and there will be some move­ment in bond yields. “The prob­lem this year is the pol­i­tics are re­ally un­sta­ble,” he says. “It would not be an un­rea­son­able thing right now for in­vestors not to buy bonds. They sim­ply may not want to give the govern­ment money to hold for the next 30 years. All that could change if the sit­u­a­tion clears up, but it could drag on with fis­cal bat­tles un­der­min­ing fis­cal and pol­icy cred­i­bil­ity.”

Keenan says bond in­vestors, par­tic­u­larly for­eign­ers, have al­ready adopted an un­der­weight stance be­cause of down­grade fears and the Re­serve Bank’s rate hik­ing cy­cle. “What we have seen is SA bond in­vestors hold­ing out for bet­ter lev­els to buy the bonds be­cause if we get a down­grade, more rate hikes and more rand weak­ness, it could present bet­ter buy­ing op­por­tu­ni­ties. If these things come to bear, we could see more sell­ing pres­sure, but there­after there would be good en­try lev­els to buy SA bonds as we could have el­e­vated yields.”

Keenan sug­gests buy­ing shorter-dated bonds, with ma­tu­ri­ties of one to seven years, and go­ing un­der­weight bonds in the 10- to 30-year bas­ket. As in­ter­est rates rise, bond prices will fall — and the bonds at the longer end of the curve with a higher du­ra­tion will weaken pro­por­tion­ately more.

“You want to lock in at the high­est pos­si­ble rate and we are not yet at that peak of the hik­ing cy­cle. The mar­ket is look­ing for another 100 ba­sis points of rate hikes, so get in later and lock in at a higher yield,” says Keenan. “The short end of the curve is the place to be — you want to short the bench­mark. I think a lot of rate hikes are al­ready priced into the mar­ket, which could help keep a lid on short end bond yields, while the long end of the curve re­mains very ex­posed to those down­grade fears.”

The al­ter­na­tive view which could help stave off a down­grade, says Can­ter, is if the weak rand leads to an im­prov­ing trade ac­count, while com­mod­ity prices rise and the global econ­omy im­proves. That could lead to a bet­ter growth out­come for 2016.

“It’s an out­side sce­nario, but not off the ta­ble,” Can­ter says. “It’s a very easy year to get it wrong on the bond mar­ket.”

SA in­vestors typ­i­cally gain ex­po­sure to the bond mar­ket via funds that are bench­marked to the all bond index, which is com­posed mostly of SA govern­ment bonds and bonds is­sued by paras­tatals such as Eskom and Transnet.

Bhag­wan says there are a num­ber of op­tions for in­vestors want­ing to hedge their port­fo­lios against a down­grade — in­clud­ing re­duc­ing the du­ra­tion of their bond port­fo­lio by switch­ing some or all of it into a cash bench­mark to us­ing op­tions to pro­tect against a fall in mar­kets. “We think there is also merit in re­duc­ing ex­po­sure to bonds is­sued by state-owned en­ter­prises as their credit spreads are likely to widen due to the close link­ages between their fi­nan­cial po­si­tion and im­plied sup­port from the state,” he says.

But he says it may al­ready be too late to buy credit de­fault swaps. In­fla­tion-linked bonds could of­fer some pro­tec­tion as they don’t re­act as vi­ciously to a sov­er­eign bond sell-off and are gen­er­ally met with buy­ing sup­port above a real yield of 2%.

“In­fla­tion-linked bonds are go­ing to out­per­form nom­i­nals in the cur­rent en­vi­ron­ment as they will be in­su­lated from the higher in­fla­tion,” Keenan says.

In­vestors should also con­sider hedges that act as a proxy hedge for a de­cline in the value of a bond port­fo­lio, says Bhag­wan. For in­stance, hedg­ing ex­po­sure to the rand by in­creas­ing ex­po­sure to for­eign cur­rency de­nom­i­nated as­sets, such as rand hedges. He also sug­gests hedg­ing or se­lec­tively sell­ing out of those eq­ui­ties that are most sus­cep­ti­ble to a sov­er­eign down­grade, in­clud­ing Telkom and the four large banks, whose own rat­ings would also be down­graded and which would suf­fer from de­te­ri­o­ra­tion in the econ­omy.

“It’s not a time to take big bets,” says Can­ter. “In­vestors should find some safe spa­ces; pay down their home mort­gages be­cause in­ter­est rates will be ris­ing; eq­ui­ties don’t of­fer much pro­tec­tion; and the money mar­ket is safe, but with low re­turns. In­fla­tion-linked bonds, the shorter-dated ones, are of­fer­ing a real yield of 1.6% so that’s a rel­a­tively safe space.”

Left: Michael Keenan Right: Shalin Bhag­wan

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