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.

Finweek English Edition - - FUNDFOCUS - Man­agers. is head of fixed in­come at Pru­den­tial In­vest­ment

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.

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