South Africa’s investment-grade credit status hangs by a thread after S&P Global Ratings cut the country’s debt to junk and Moody’s Investors Service placed it on review for a downgrade.
The state of play
S&P now rates South Africa’s foreign-currency debt BB+, one level below investment grade, with a negative outlook. Fitch Ratings and Moody’s assess the nation’s creditworthiness at BBB- and Baa2, one and two levels above sub-investment, respectively. Both have a negative outlook, meaning they’re more likely to lower than raise the credit score. At the same time, S&P reduced its rating for the nation’s local debt one step to BBB-, the lowest investment grade. Moody’s rates the local-currency debt at Baa2, two levels above junk, while Fitch’s assessment is BBB-, one rung above junk.
What happens next?
A one-step downgrade of the foreign-currency debt by Moody’s wouldn’t change the picture substantially, as South Africa would still be left with two investment-level ratings. A two-notch downgrade by Moody’s or a cut by Fitch would spark forced selling of foreign-currency bonds by investors that track investment-grade debt indexes.
On the local-currency front, it would require a one-step downgrade by Fitch and a two-notch cut by Moody’s, or another by S&P, to trigger forced selling from local-currency bond-index tracker funds. There is less danger of that happening immediately.
Why does it matter?
Bond indexes compiled by Bloomberg Barclays, JPMorgan Chase & Co. and Citigroup Inc., which are tracked by more than $2 trillion of institutional funds, have rules relating to the credit quality of constituents. Broadly speaking, those rules require an investment-grade rating, either from S&P (in the case of Citigroup’s World Government Bond Index) or from two of the three companies (in the case of the Bloomberg Barclays and JPMorgan emerging-market indexes). Hard-currency indexes, such as the Bloomberg Barclays Global Aggregate Index and JP Morgan’s EMBIG gauges, look at the long-term foreign-currency ratings, while local-currency indexes like the WGBI focus on the local-currency rating.
Should South Africa lose its membership of these indexes, funds that track them would be forced to sell their holdings of South African bonds. In addition, funds that are mandated to hold investment-grade debt only would be forced to sell.
What’s at stake?
Foreign investors hold 36 percent of South Africa’s 1.74 trillion rand ($129 billion) of local-currency government bonds, according to the National Treasury’s February budget review. That means an amount of 623 billion rand is potentially at risk in a selloff, in addition to about $16 billion of debt denominated in foreign currencies. Foreign-currency bonds account for about 10 percent of South Africa’s total government debt of 2.2 trillion rand.
In practice, the amounts will probably be less. UBS Ltd. estimates that WGBI-tracking funds account for about 22 percent of non-resident bond holdings, or about $10 billion of South African local-currency debt, roughly the same amount as the current-account deficit. A forced sell-off by funds tracking the gauge could double the shortfall in nominal terms.
What are the precedents?
Turkish and Brazilian bonds fell after they were first downgraded to junk, in September 2016 and September 2015, respectively. Turkish local government debt lost 5.1 percent in the month after the nation was cut to Ba1 by Moody’s, the worst performance among 31 emerging markets monitored by Bloomberg. Its Eurobonds lost 2.4 percent, more than three times the average for developing-nation dollar notes in that period. Brazilian real-denominated government bonds dropped 0.73 percent in the four weeks after S&P moved it to BB+, while emerging-market local government bonds gained 2.7 percent on average.
By contrast, Russia’s assets outperformed after it was first cut to junk by S&P in January 2015. The country’s local debt and Eurobonds gained in the following month, while those of its emerging-market peers fell.