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Moody’s downgrade: Expected, but timing disappoints

| Market Forces

Like many developing countries, 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’s important that we keep our credit rating healthy. Investors and credit rating agencies are increasingly concerned about our ability to bring our debt levels down and avoid a debt trap.

The Moody’s ratings downgrade to sub-investment grade on Friday, 27th March, (Ba1 negative) was not unexpected, as South Africa’s fiscal outlook has deteriorated materially, the economy is mired in a recession and investment sentiment is weak. Moody’s estimates that SA’s debt-to-GDP ratio will rise to 91% by 2023, well ahead of the figures Treasury announced at the time of the Budget. In addition, the inability of Eskom to adequately supply electricity remains a further headwind for the economy.

The timing of the Moody’s decision could not, however, have come at a worse time given the spread of the COVD-19 virus both domestically and globally.  One would have hoped that Moody’s would have given the country a reprieve until later in the year.  Nonetheless, the Moody’s decision now aligns the sovereign rating with that of Standard and Poor’s and Fitch and removes a whole lot of uncertainty from the bond and currency markets.  Looking ahead, South Africa will now be grouped along with other emerging economies, most of whom are already sub-investment grade.  This will allow for a more equitable and comparable pricing of debt.

Today will be pivotal for the bond market in that participants will see to what extent the downgrade has been priced into the market.  The sharp rise in both nominal and inflation-linked bond yields over the past two weeks suggests that the downgrade was at least partially priced in, although a liquidity squeeze in the market also accounted for some of the increase in yields.

From a multi-manager house view perspective, we believe a further buying opportunity is therefore expected to present itself in the near term, across both the nominal and inflation-linked bond market.  As a consequence, we recommend increasing the overweight position to domestic bonds, but at yields in excess of 13% on the All Bond Index and real yields in excess of 6% for inflation-linked bonds.   The increase in inflation-linked bond yields does, however, pose a material headwind for defined benefit funds in that margin calls will persist, risking the solvency positions of funds and contributing to a liquidity squeeze. Although the SARB announced its version of QE, whereby the bank will buy debt across the entire curve, it has indicated that its bond buying operation is not QE, but merely ensuring adequate liquidity in the bond market.  It therefore doesn’t aim to influence the price at which bonds trade.  This is rather disappointing given that QE is being adopted by many central banks globally, ensuring interest rates are accommodative and stimulate their economies.

We have also contacted a few of our key fixed income managers to gauge their views on the credit downgrade. This is discussed in the document attached.

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