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
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