Written by Gyongyi King, Chief Investment Officer, and Lesiba Mothata, Executive Chief Economist

S&P Global Ratings has, for the first time since ratings were solicited, downgraded both the 90% of South Africa’s debt issued in local currency and the 10% in foreign currency to non-investment grade, while Moody’s and Fitch have left their ratings unchanged.

This means the average effective credit rating for South Africa is now non-investment grade (illustrated below). Although this outcome will not trigger South Africa to immediately be excluded from the Citi World Government Bond Index (WGBI), one of the major global bond market benchmarks, investors will soon factor in the imminent explosion once Moody’s makes its decision, possibly after the ANC elective conference in December.

The Barclays Capital Aggregate Bond Index is also a very important benchmark for bond investors. It is from this index, which requires an average rating of investment grade from all three agencies, that South Africa will be removed. For bond investors obligated to track the Barclays Capital Aggregate Bond Index, there could be outflows of approximately R70 billion. Investors replicating the Citi WGBI, however, would not need to sell out of their holdings in South African debt as yet. Should Moody’s downgrade South Africa’s debt in local currency, this could induce outflows of approximately R140 billion. This would be from investors meant to replicate the index weight (passive investors) without taking off-benchmark positions.

Credit quality of selected emerging market countries and average effective credit rating in foreign currency

AF - credit quality & investment grades for emerging markets

However, not every investor is obliged to replicate the holding of South African debt commensurate to the weightings in indices. These types of investors, who are speculative in nature, can take positions markedly different from the indices and are not obligated to sell South African debt following the downgrade. It is, therefore, not a given that substantial outflows will become an eventuality following this downgrade. In fact, data from the Institute of International Finance indicates that the United States has been the largest source of equity inflows into emerging market countries, while the euro area accounts for most of the debt inflows. Given that around 50% of outstanding debt in Europe is yielding negative interest rates, demand for emerging market debt, including South Africa’s, has a natural underpin.

The downgrade of South Africa’s debt denominated in local currency has been long anticipated. Fund managers have been taking money offshore and scaling down their allocation towards South African bonds. Data from the Alexander Forbes Manager Watchᵀᴹ Effective Asset Allocation Survey indicates there has been an increased allocation towards offshore assets to the maximum level allowable by regulation, 25%, up from around 17% in 2009. The allocation to South African bonds was around 10% for most of the period between 2009 and 2014. Since Nenegate (at the end of 2014) there was an increase in the bond allocations to as high as 15%. But since the beginning of this year there has been a notable decline in bond allocations. A similar picture emerges from the Bank of America/ Merrill Lynch Fund Manager Survey.

These outcomes — higher offshore allocation and reduced holdings of South African bonds — are consistent with a market anticipating further ratings downgrades, a weakened fiscal position, a potential equity market sell off, and a weak rand.

Alexander Forbes Investments continually monitors and reviews its portfolios in a Living*Investing framework to ensure they are aligned to meet clients’ objectives. Living*Investing is a risk-led, forward-thinking investment approach aimed at achieving client objectives with a greater degree of certainty. In line with this framework, our portfolios have positions designed to protect against credit ratings downgrades and rand weakness. Based on this, the following actions have been taken:

AF - maximum offshore icon
Investments in offshore markets provide downside protection when the rand weakens. Due to the relative attractiveness of offshore equity valuations, additional diversification against South African market weakness is built into our portfolios.

AF - high rand hedge quality icon
Of the total listed companies on the Johannesburg Stock Exchange, on average, approximately 55% of earnings is derived from offshore. Our portfolios have exposure to these companies, which benefits during periods of significant rand depreciation.

AF - less interest rate risk iconInvesting in long-dated bonds introduces interest rate risk. Our portfolios are generally concentrated on bonds with short-dated maturities — to protect against a significant rise in interest rates associated with downgrades — along with inflation-linked bonds, which are also defensive and provide a hedge against inflation induced by currency weakness.

AF - defensive in cash iconDuring periods of market declines, cash provides downside protection. Our portfolios have a higher than normal weighting to cash. If the South African Reserve Bank responds to the downgrades with higher interest rates, the exposure to cash will act as a hedge, but can also be deployed when attractive opportunities arise.

AF - diversified into alternative assets iconIn response to the lower return environment, alternative assets, which provide greater diversification benefits, have been included in some of our portfolios. Our portfolios are now exposed to a wider opportunity set, including hedge funds and private markets (both local and offshore), which have lower correlations to public markets.

What will ensue in South African markets will be punctuated by heightened volatility. Global conditions are constructive and supportive of South Africa at the moment, without which domestic conditions would have been worse. It is, however, very important to stay focused on the long-term goal without capitulating during volatile times. Investors should look through the cycles and keep invested for the long haul. It’s in these environments that a risk-led investment approach is needed to protect portfolios on the downside and accumulate from the higher base. We employ a risk management approach to help improve the probability of achieving our clients’ desired outcomes.

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