R16tn SA debt at risk

JUNK STATUS: FORCES INSTITUTIONAL INVESTORS TO SELL RAND DEBT

Systemic rules aimed at preventing noxious debt from infecting world markets forces big, institutional investors to sell any debt on their books when it’s downgraded to junk, like South Africa’s has been.

South Africa’s investment-grade credit status and a R16 trillion selloff of our debt hangs by a thread after S&P Global Ratings cut the country’s debt to junk on Monday.

S&P now rates South Africa’s foreign-currency debt BB+, one level below investment grade, with a negative outlook. Fitch Ratings and Moody’s assess the nation’s creditworthiness at BBBand Baa2, one and two levels above sub-investment, respectively.

Negative outlook

Both have a negative outlook, meaning they’re more likely to lower than raise the credit score.

S&P reduced its rating for the nation’s local debt one step to BBB-, the lowest investment grade. Moody’s rates the local currency debt at Baa2, two levels above junk, while Fitch’s assessment is BBB-, one rung above junk.

A one-step downgrade of the foreign currency debt by Moody’s wouldn’t change the picture substantially, as South Africa would still be left with two investment-level ratings. A two-notch downgrade by Moody’s or a cut by Fitch would spark forced selling of foreign currency bonds by investors that track investment-grade debt indices.

On the local currency front, it would require a one-step downgrade by Fitch and a two-notch cut by Moody’s, or another by S&P, to trigger forced selling from local currency bond index tracker funds. There is less danger of that happening immediately.

Bond indices compiled by Bloomberg Barclays, JPMorgan Chase & Co and Citigroup, which are tracked by more than $2 trillion of institutional funds, have rules relating to the credit quality of constituents.

They require an investment-grade rating, either from S&P (in the case of Citigroup’s World Government Bond Index) or from two of the three companies (in the case of the Bloomberg Barclays and JPMorgan emerging-market indexes).

Hard currency indices, such as the Bloomberg Barclays Global Aggregate Index and JP Morgan’s EMBIG gauges, look at the longterm foreign currency ratings, while local currency indices like the WGBI focus on the local-currency rating.

Should SA lose its membership of these indices, funds that track them would be forced to sell their holdings of South African bonds. In addition, funds that are mandated to hold investment-grade debt only would be forced to sell.

Foreign investors hold 36% of South Africa’s R1.74 trillion ($129 billion) of local currency government bonds, according to the National Treasury’s February budget review. That means an amount of R623 billion is potentially at risk in a selloff, in addition to about $16 billion of debt denominated in foreign currencies. Foreign currency bonds account for about 10% of SA’s government debt of R2.2 trillion.

In practice, the amounts will probably be less. UBS estimates that WGBI-tracking funds account for about 22% of nonresident bond holdings, or about $10 billion of SA local currency debt, roughly the same amount as the current account deficit.

Hard lessons

Turkish and Brazilian bonds fell after they were first downgraded to junk, in 2015 – local government debt lost 5.1% in a month; its Eurobonds lost 2.4%. Brazilian real-denominated government bonds dropped 0.73% after S&P moved it to BB+, while local government bonds gained 2.7%.

By contrast, Russia’s assets outperformed after it was first cut to junk by S&P in January 2015.