Please forgive the more technical article around the downgrade. We as a team felt it was important to explain what the recent downgrade of SA government debt means for the government and our investors.
Friday the 27th of March 2020 will stick in the minds of the investment community for a very long time to come. After suffering heavy falls in investments since the 20th of February, Moody’s, the last remaining rating agency with South African Government debt at Investment Grade, downgraded South Africa to ‘junk”
Before we dive into the impact of this, let’s take a few steps back. Moody’s is one of three global rating agencies’, the others being Fitch and Standard & Poors. One of their most important roles is to rate the creditworthiness of debt issued by governments and large companies. Each rating company has their own scale but simply put, debt can either be “investment grade” or “sub-investment grade”, also known as “junk”
This rating has a major impact on the interest at which debt is issued. Sub-investment grade debt has a higher interest than investment grade. Higher interest payments mean more of the government or companies revenue goes towards serving interest costs. It also limits the spread of investors available in the debt.
Some pension funds, insurance companies, banks and other institutions limit themselves to only investing in debt that is rated investment grade, or above. The immediate impact of a rating’s downgrade for South Africa means that many of these investors can no longer hold South African government debt and need to sell.
It’s very important to understand where this has an immediate impact and where it doesn’t. The table below shows you a broad range of interest rates from the cash and bond markets. The South African Reserve Bank controls the Repo rate, and the rate that banks lend.
The major impact of the ratings downgrade and COVID-19 is, at the moment, mostly visible in long-term government debt (highlighted below). This debt is bought and sold by different investors every day, and the use the rate below as a way to value the SA government’s ability to repay and that changes the price they are willing to buy and sell government debt at.
You can see that the yield on government debt has increased considerably over the last month, mostly as a result of the impact of the Coronavirus, and it is here too that the ratings downgrade could further increase this interest rate.
Source: Refinitiv, Datastream.
Some of these bonds are held in the CoreShares OUTcautious, OUTstable and OUTmoderate Funds to varying degrees, as a way to reduce the short term volatility of the portfolio. Unfortunately, as a result of the downgrade and the impact of COV-19, these portfolios will suffer a fall in performance. The exact figures will be known in the coming weeks.
It’s important to note that this is not necessarily a permanent reduction in the value of those Funds, as mentioned earlier, these bonds are valued every day, and every day their value changes, for a multitude of reasons. For example, now that South Africa is sub-investment grade, our debt is now extremely attractive to some investor types and as they step in and buy SA government debt, the yields reduce and the prices rise. It is unlikely they will rise back to their pre-downgrade levels, for that to happen South Africa has to have economic growth, reduction in unemployment and a reduction in government borrowing.
For those who want to know more, the press release from National Treasury is well-written, clear and concise. You can read it here.
OUTvest is an authorised FSP.