Downgrades: should we panic?

Demand for local bonds has attracted massive interest, says expert.

November’s further downgrade of local and foreign currency by S&P and the looming threat of a similar Moody’s downgrade has raised concerns about further future downgrades to non-investment grade.

There’s no immediate reason for investors to panic, but note the impact of the latest downgrade and what further impact could be expected. TreasuryOne’s Phillip Pearce says demand for local bonds, despite being downgraded, has attracted massive interest and investors decided the return outweighs the risks. “The portfolio inflows have bolstered the rand, as it is apparent global markets are yield-hungry in an environment of persistently-low interest rates in the face of lackluster inflation.”

The estimated $3.7 billion of SA bond exposure cut from The Barclays Global Bond indices will result in excess supply issues for the local bond market, as SA’s excluded from global bond indices. The SA bond market could then enter a period where bonds offer relative value to emerging markets (EM) peers until the selling abates or is absorbed.

The Citibank World Government Bond index (WGBI) exclusion will only occur if Moody’s downgrades SA debt to junk. If this occured however, more exposure to SA bonds would be cut.

It’s important to view the SA sovereign risk premium with other junk status economies like Brazil and Turkey. We’ve seen little movement in SA bond yields and this should maintain in 2018, unless the market starts to expect additional downgrades – then we’ll see a change in the relative risk premia. SA yields are lower than Turkey and Brazil, because the market attaches a lower currency risk premium to the rand. This is based on a strong central bank that’s been successful in managing inflation under 6%.

SA sovereign risk premium has priced in junk status already.

Within this scenario, it’s critical to watch EM flows. If EM bonds remain an attractive asset class, this will keep supporting SA bond yields and result in a muted move in yields in the face of downgrades. If EM flows reverse, all EM bond market yields will likely rise and SA bonds will be exposed to index exclusion and EM outflows.

Comparing the SA bond market against other EMs shows its resilience to ongoing credit downgrades by ratings agencies. This may in part be due to the comparative Sovereign Bond Yields of other EMs. SA bonds appear fairly priced and reasonable value against EM peers. As bonds are excluded from the indices following downgrades, they may show relative weakness on excess supply and we’d expect to see active investors in EM funds enter the market.

While there’s no immediate reason to panic, investors must be aware to re-evaluate risk if the status quo changes. Waning of the overall appetite for EM bonds; deterioration of SA’s fiscal metrics that could lead to further credit rating downgrades and possible SA Reserve Bank intervention could all impact the 2018 SA bond risk profile. A shock in the ANC elective conference’s outcome could equally change our risk profile.