Downgrade not a calamity for bond investors Why the impact of the possible downgrade of SA’s sovereign debt to junk will not be as negative as one might think.
while the possible downgrade of South Africa’s sovereign foreign currency credit rating to below investment-grade (or “junk”) status later this year does present a shortterm risk to bond investors, there are several reasons to believe that the medium- to longerterm impact on the bond market may not be as negative as many investors believe.
Markets have largely discounted a downgrade
By several measures, markets have already built in a risk premium, anticipating and discounting a move to junk status. SA’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 4.1% 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.
South African bonds have also substantially priced in the risk of a downgrade: Since January 2015, the 10-year government bond yield has already risen from around 7% to over 9%. This is roughly equivalent to, or higher than, yields in Turkey, India, Indonesia and Russia. Investors are already demanding much higher yields for the rising risk presented by holding our bonds.
Given that our bond yields have already risen well over 2 percentage points in anticipation of a downgrade (and higher inflation), it is less likely that there will be a further large spike in yields when the event actually occurs. In fact, an examination of the experience of other countries downgraded to junk status confirms this.
The graph 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.
Consequently, if SA follows the pattern of these countries, it is reasonable to expect some further rise in yields from current levels ahead of a downgrade – but a large spike would depart from the norm. Then, once the downgrade has occurred, our bond yields would likely rebound over the next 12 months, leaving bondholders (from this point in time) no worse off than prior to the downgrade, or even better off. In fact, countries like Portugal and Hungary fully recouped their bond losses within 12 months or less.
Importantly, any “forced selling” by offshore investors (such as bond index-tracking funds) not allowed to hold sub-investment grade assets will likely be limited. This is because SA’s inclusion in the World Government Bond Index depends on maintaining our
(rather than our foreign currency rating) at investment grade. This rating is not expected to fall below 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). In our view, the yields of over 9% on long-dated South African 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 longterm inflation anchored at 6% in our view, this translates into real yields of over 3%, significantly above our long-term fair value estimate of 2.25% for this asset class. Consequently, we are overweight in these bonds in our multi-asset class portfolios like the Prudential Inflation Plus Fund, Prudential Balanced Fund and Prudential Enhanced Income Fund.