CREDIT RATINGS DOWNGRADES – WHAT ARE THEY ALL ABOUT?

Credit agency ratings will therefore be a factor that investment managers take into account when they decide the terms on which they are willing to lend money, but there will be other factors too including the manager’s own assessment of credit risk.

This is clear from the answers given by managers to our second question below.

Even so, investors will tend to pay attention to a downrating, especially when more than one agency downgrades the same borrower. This is obvious – the downgrade does not happen in a vacuum, but reflects concerns that will usually be shared by many investors.

If a country was generally rated BBB last month, but is downrated to BB+ (sub-investment grade) while other countries retain their BBB ratings or better, the agencies are saying that, in relative terms, the country’s credit risk has increased.

Most likely this is also the perception of the investment community in general.

The effect will be that lenders are less keen to buy the country’s bonds, and will ask for better terms (a higher interest rate, or earlier repayment) than they would have done previously. This makes it more expensive for the Government to borrow.

There will be a knock-on effect for other borrowers such as the banks and large companies, especially if they are trying to borrow from foreign investors – they will also have to pay more, e.g. via higher interest rates.

How does South Africa’s rating compare to other countries?

Countries like Germany and the USA have the best credit ratings – Germany is rated AAA for its foreign currency debt by all three of the big agencies.

Of the other BRICS nations, China and India have investment-grade ratings while Brazil and Russia are generally rated below investment grade. (Fitch has a BBB- rating for Russia.).

Turkey, another country to which South Africa is often compared, is also below investment grade, as are Nigeria, Egypt and Kenya (both in the single-B band). Botswana has a single-A rating.

Will the downgrade lead to disinvestments by foreigners who have bought our Government bonds?

To some extent, yes, however, as noted above, investment managers are not slaves of the rating agencies, but make independent decisions.

Managers also try to anticipate future developments – the rating agencies can be slow to make decisions (for instance, the on-going Moody’s review of SA’s rating has been in the pipeline for several weeks), and so the managers may act in advance of ratings changes that they know or suspect are on the way.

In other words, some selling may happen even before downgrades are announced.

In addition, the prevailing global investment climate is generally positive for emerging-market bonds (a category into which South Africa falls).

This is because the interest rates paid by bonds issued by developed-world borrowers like the US, UK, Germany and Japan are extremely low.

Investors therefore remain willing to take some risk by investing in bonds from countries like Brazil, Turkey or South Africa, because these pay significantly higher interest rates.

Having said that, there are some technical issues that could give rise to some “forced selling” of RSA bonds.

Some investment managers may have restrictions imposed on them by their clients (such as the large pension funds) which prevent them from holding sub-investment grade or “junk” bonds in their portfolios.

Ideally, if the bonds were investment grade when the manager first bought them, the clients’ rules will not force the manager to sell these bonds when they are downgraded, but the manager may not be allowed to buy more of them.

But this would still tend to reduce the demand for RSA bonds once they fall to “junk” status.

Secondly, the various firms which compile indices of bond market performance have their own rules as to which bonds to include in their indices. There are various indices of the performance of investment-grade bonds.

At some point after RSA bonds fall to “junk” status, the index construction rules will mean that the RSA bonds are removed from the index.

Investment managers who are benchmarked against well-known indices like the Citigroup World Government Bond Index or the J P Morgan Global Government Bond Index may not wish to hold bonds that no longer form part of these indices, or their investment mandates may actually prevent them from doing so.

More importantly perhaps, if a bond portfolio aims to track the performance of, for example, the Citigroup index, the manager will only want to hold the bonds which make up the index, in the correct proportions, and will need to sell bonds that are removed from the index.

The extent of index tracking in the global bond market is hard to assess, but there are estimates that possibly some R100-billion of “forced selling” of RSA bonds could be looming over the coming months, if and when the country is removed from the investment-grade indices.

The timing and impact of this forced selling is uncertain, and if demand to invest in emerging-market bonds remains high the sellers might quite easily find new buyers for these RSA bonds. But this cannot be a good thing.

But what has actually happened to our bond market, since the downgrades started?

There was a sell-off in the local bond market in the last week of March, and the Rand also weakened significantly.

However, since then the Rand has been reasonably steady against the major developed-world currencies, and the bond market recovered well during April.

As we noted earlier, this may be more a result of the prevailing global environment, and foreign investors’ hunt for higher-yielding investments, rather than a specific response to the downgrades.

Of course, investors may be awaiting further developments. Brazil’s debt was downgraded to “junk” status by early 2016, amid the political instability leading to the impeachment of President Rousseff in September 2016.

However, in the months following the downgrades, Brazil had net inflows of bond investment, and the prices of government