Before someone throws a banana and boos us off stage, let’s make the following clear: It’ll be a sad day when/if we are downgraded to junk and we know there will be negative consequences. If we thought there was a chance of us avoiding it, we would’ve chosen a different title for this piece. Please hear us out.
A credit rating is an indicator of how likely a government or corporate is to pay back loans made to them. Being downgraded to junk means the risk of non-payment is higher than it would be when lending to an investment grade entity.
The primary reason we fret over SA being downgraded is that our bond yields will increase to compensate investors for the additional risk. This would make borrowing more expensive for both our government and businesses, neither of which need additional challenges.
The secondary concern is that the rand will depreciate because foreigners will be net sellers of our bonds. This could see inflation become a problem and interest rates may have to rise – also not good. But what if our bond yields fell post the downgrade and instead we enjoy the positives of such an outcome? We think there’s a good chance it happens.
A stay of execution from Moody’s would require our politicians to suffer acute short-term pain; think loss of party support as government jobs are slashed and SOE’s are sold to the private sector. They are simply not incentivised to endure such torment, and as a result, they are unlikely to make the changes necessary to avoid the downgrade. We think the market already knows this.
Being junk in the collective mind of the market, but not on paper, is undesirable because it creates uncertainty about what is priced in and what isn’t. We think that same doubt is stopping investors keen on SA bonds from pulling the trigger. We say this with a certain amount of conviction because of what has happened in Brazil.
To reiterate, the conventional story is that a downgrade will cause yields to blow out in a sustainable fashion as forced selling kicks in, sans investors there to pick up the extra supply. But the tale of Brazilian bonds suggests another possibility entirely.
They were downgraded to junk by all three ratings agencies within the space of 6-months, beginning September 2015. Since then, their bond yields have fallen from a peak of 16,8% down to a recent November 2019 low of 6,4%.
Remember that a falling yield means that bond prices are rising, a clear sign that there were plenty of investors to pick up the extra supply. The magnitude of this move is gigantic and would have delivered a mouth-watering return to the savvy investors who rode this beast.
In case you think we’re telling you porky pies, the evidence is visible below in the only chart we’re going to show you today. The red line is the yield of the 10-year Brazilian Government Bond. Falling off a cliff springs to mind.
We haven’t happened upon Brazil by chance. They are a commodity exporting country, like us. They run punchy budget deficits, like us. Their debt-to-GDP is 77%, worse than us, but we’re trying to catch them. And they have a solid brand of government corruption.
Our fundamental economic similarities are such that our currencies, inflation, and bonds tend to track each other quite closely over time. A relative if you will.
The message to take away from the chart, and this piece for that matter, is that despite being downgraded to junk, Brazil’s bond yields have compressed aggressively.
Why/how did this happen? Because Brazilian inflation (blue line) has collapsed. Inflation is one of the most fundamental drivers of bond yields, and this doesn’t seem to change when you lose you’re investment grade rating.
Now, back home, South African inflation has also eased (from 7% to 4%), and yet our bond yields, from already elevated levels, have drifted sideways, or risen depending on your starting point.
We think our yields are staying stubbornly high because of the uncertainty that a pending downgrade from Moody’s is casting into the minds of potential investors.
Red herring ratings and what really matters
We have looked at the ‘junking’ of Brazil, Turkey, Russia, Hungary, Portugal, Romania, and Uruguay and there is no conclusive evidence that the official stamp of ‘junk’ ushers in a sustained period of rising bond yields.
If there were any findings, they were that, 1) bonds price in the downgrade long before it’s made official, and 2) that bond yields ultimately dance to the drum of inflation.
Given that the real yield on our 10-year government bond is roughly 4,9%, compared to 4,3% on its Brazilian counterpart (already junk status), we’d say the downgrade is already reflected in the yields of South African bonds. In other words, the market already sees our debt as non-investment grade.
And once/if Moody’s makes us bona fide junk, removing the uncertainty, we’re suggesting that the global bond investors lying in wait will pounce on our juicy yields. Fun fact to further support the proposed demand for our rich yields: nearly half of all global 10-year government bonds are negative yielding.
The caveat to this bullish stance on bonds is that our inflation must remain contained, and that global bonds don’t enter a bear market. This means that global growth must remain healthy enough to support emerging markets but mustn’t accelerate so hard that significant inflationary pressures enter the system. This is our base case. If these assumptions are not in place when the downgrade happens, we wouldn’t expect yields to compress.
Aside from the attractive returns (most likely double digits) that SA bond holders will receive if our yields compress from current levels, we could also expect the following positive developments;
We believe that the market already views South African bonds as non-investment grade, and that it’s unlikely we prove them wrong. This is reflected in our incredibly attractive real yields, which are, in many cases, higher than those of other countries already branded junk.
There is no conclusive evidence that being downgraded to junk causes a sustained blowout in yields; what happened in Brazil is an excellent example of how inflation, and not credit ratings, determine the direction of bond yields and prices.
South Africa’s attractive yields should have already compressed because our inflation has fallen precipitously. And there are real benefits to be had when/if they do. But until our junk status is made official, the demand for our bonds will remain behind the flood gates, with investors adopting a wait-and-see approach.