Eugene Visagie, CFA®, FRM® Client Portfolio Manager – Morningstar Investment Management South Africa

On Friday, 27 March 2020, news broke that rating agency Moody’s cut South Africa’s sovereign credit rating to sub-investment grade. South Africa now has a sub-investment rating from all three major international rating agencies. What will this mean for South African bonds?

Let’s first look at what it means to be downgraded.

Think of it as a credit score from your bank manager – the less likely you are to default on your debt repayment, the better your score will be, whereas a weak score would indicate that you are more likely to default, and not be able to repay your debt.

When you have a bad credit score and you are seen as someone that could potentially not repay a loan, the establishment extending the credit to you assumes more risk in lending the money to you (as opposed to someone with a better credit score). Therefore, the credit provider will charge a higher interest rate to be compensated for the increased level of risk it assumes in lending you the money.

In the same manner, South Africa is rated on its ability to repay its debt and is charged more when it has a bad credit rating. The downgrade, therefore, raises the question of how much more South Africa will have to pay for its debt going forward.

Already priced-in?

When comparing South African bonds to other emerging markets, South Africa was paying more for its debt compared to other emerging markets (see graph on the next page) even before the downgrade. This means that investors already viewed South Africa as non-investment grade and our bond yields had adjusted to reflect this.

As an example, you can buy a 10-year South African government bond and earn a real yield (yield after inflation) of 4.7% compared to a 10-year Brazilian bond that only pays a real yield of 2.6%. Brazil has been sub-investment grade since 2016 and in theory, should be paying more for their debt than South Africa.

So, the question begs – why has South Africa been paying more for its debt than other emerging markets that are sub-investment grade?

It is not due to the poor economics of South Africa and rising debt levels as all countries have debt and most of our peers have higher debt levels than South Africa. We would argue that global investors do not like uncertainty and the fact that South Africa has been threatened with a Moody’s downgrade for the last 18 months. This led to global investors taking a wait and see approach rather than investing in our sovereign bonds.

Where to from here?

Currently, 10-year South African government bonds are yielding close to 12%, which means that if you buy a 10-year South African government bond now and hold it until maturity, you will receive coupons every year of 12%. Considering that inflation is close to 4.5%, this is a healthy return on investment and equates to a real yield (after inflation) of close to 7.5%.

It’s worth noting that many developed market sovereign bonds currently have negative real yields. This means that over time the value of your money will decrease if you invest in many developed market bonds. It’s no secret that investors need positive real returns from their investments in order to meet their liabilities.

A concern highlighted by many market participants is the fact that South Africa will lose its place in the World Government Bond Index (WGBI) following the downgrade from Moody’s to sub- investment grade. This has been one of the consequences of the downgrade that has left many investors worried, in that it would lead to foreign investors being forced to sell South African bonds and cause the price to fall. While this concern is valid, there are two important factors to consider.

Firstly, many foreign investors left our market in March due to the risk-off trade and panic selling caused by the COVID-19 virus. Secondly, although South Africa will exit the WGBI (where we made up less than 0.5% of the index) we will now be included in sub-investment grade indices such as the Global High Yield index. In the latter index, South Africa will have a larger weight of 5% and be an attractive option for investors looking to invest in this index.

In addition to this, government bonds provide portfolio protection against a strengthening rand. While the rand has weakened dramatically over the past few weeks, we believe it is now looking oversold. We are also confident that investors will reinvest into our market once the COVID-19 noise subsides.

In closing

We believe that, even though market conditions are challenging, it is precisely at these times that one needs to focus on the fundamentals and take advantage of mispricing and golden opportunities.

Achieving positive portfolio outcomes continues to be our long-term focus, which is driven by a willingness to be different from others and in applying a disciplined investment approach. In our opinion, the Moody’s downgrade was priced in before March and South African government bonds currently present an excellent investment opportunity.