South African sovereign credit downgraded – Welcome to High-Yield!

A widely held cynicism in Economics is that the primary role of a ratings agency is to arrive on the battle-field once the fight is over, and bayonet the wounded. As the clock struck midnight on Friday the 27th of March, came the long-anticipated announcement from Moody’s that South Africa’s last remaining investment-grade credit rating was removed – our proverbial bayonetting moment is now upon us

The downgrade of the sovereign to Ba1 with a negative outlook means the country’s cost of borrowing increases, placing additional strain on an already-suffering Fiscus and, more than ever before,  the alarm bells of the dire need for structural and economic reform should be ringing loud and ominous in the ears of every policymaker in the land…

Notwithstanding the weaknesses brought about the Covid-19 virus and its impact on the economy, Moody’s were as clear as can be in launching the sternest of shots, no longer across the bow of government, but now broadside:

“…But, this downgrade is largely a result of government’s own making over an extended period. Theinability to implement a comprehensive package of economic structural reforms (such as quickly enabling private sector investment in power generation), to cut the expensive and wasteful cord of state-ownership and support to non-strategic, disastrously run state-owned organisations like SAA, and the fiscal crisis caused by nine years of corruption and state capture have placed South Africa in this situation. The fact that not even one of the protagonists involved in the disastrous state capture project has been prosecuted, is concerning.”

Although the downgrade was largely expected, with bond yields and the currency both trading at levels one would expect prior to an imminent downgrade, this does little to cushion the reputational impact of the country’s no longer being an investment-grade issuer. The space our government bonds and corporate credit now trade (known as ‘High Yield Bonds’, not junk) means we still have access to markets, but it’s a lot like being relegated from the Premier League down to the 2nd Division – your team still gets TV coverage and advertising revenue, but nothing like what you were getting playing in the ‘Big Leagues’.

So how will this affect us and our investments?

Like in many Emerging Market economies, the South African Government relies on funding to build and maintain the infrastructure of the country. To enjoy continued access to loans (in the form of government bonds) at affordable interest rates, it is imperative that the Government spare zero efforts in maintaining the credit rating and not pursuing the policies that have contributed to the downgrade, potentially seeing our rating fall further (EWC, NHI, Nationalisation, to name but a few). Of primary concern to everyone is the risk of South Africa falling into a ‘debt trap’, where we would not be able to service our interest payments on the debt we have, or worse, not be able to raise funding from investors at all due to our overall indebtedness. In short, Government has no choice but to reprioritise spending and pay a greater share of the National Budget towards interest payments, and less towards delivering services to the citizens – expressed differently, expect you and I to be paying more tax in the future!

One major impact of the downgrade has been, and will likely continue to be, sustained weakness of the currency. The short- to medium-term impact of a weaker Rand is the increase in the price of imported goods, thereby stoking inflation. With the preference we have long held towards offshore assets, a weaker Rand bears some good news as the weaker currency benefits your investment value when converted back into Rands.

Bonds and Fixed Interest instruments are now yielding above-inflation rates not seen in decades – with the All-Bond delivering a yield of over 12%, the current CPI+8% yield is difficult to ignore!

Our stock market has one of the most globally-diversified income streams, with roughly 40% of the total earnings of the JSE-listed companies coming from offshore sources. Many locally-listed companies have therefore become less reliant on the fate of the local economy, thereby protecting investors from rand-weakness and RSA-specific risks. With all economies across the globe facing the challenges presented by Covid-19, the Developed Markets do have stronger support from their governments to stem the flow of hardship over this time.

Once SA starts picking up the pieces after the lockdown there will certainly be enormous work to be done. But in a world where most interest rates are trading at or near 0.00%, and the ‘search for yield’grows daily to cover unfunded future liabilities, the higher yield offered by our local fixed interest market may prove juicy enough to ensure we’re not off investors’ radar-screens, and attract inflows once again.