Junkbond Status: Meltdown?

Dec 15, 2018

When it comes to its credit rating, SA had been circling the drain for some time before Standard & Poor’s Global Ratings eventually pulled the trigger after the firing of Pravin Gordhan as Finance Minister. Fitch Ratings followed suit soon after. The third international ratings agency, Moody’s Investor Service,  put the nation on review for further downgrade, including local and foreign currency debt. Gordon is now back in government and a new, corruption-busting president has been elected. This has bought SA (and the Rand) more time, but the situation remains precarious. What does all this mean?

A country’s credit rating denotes the probability risk of that country being in a position to pay back the money it borrows (for example when selling medium or long term bonds to raise capital). Credit bands range from AAA at the top end – denoting Very Low Credit Risk (e.g. the USA and other developed countries) down to Moderate Credit Risk. This Moderate band ranges from BBB+ down to BBB-.

BBB- is the lowest rung on the credit ladder that denotes Investment Grade lending risk. This is very important: the next level down (Considerable Credit Risk, or BB+) denotes Sub-Investment Grade lending risk, or Junk Status.

South Africa’s credit rating reached a high of BBB+ (on the cusp of Low Credit Risk) at the end of Thabo Mbeki’s reign as president, after steadily improving since 1994 on the back of a steadily growing economy. Since then it has fallen back, eventually settling at BBB-, the lowest rating in the Moderate Risk band. The next step down – Considerable Credit Risk (BB+) – is where the country now finds itself: Junk territory.

Naturally, the lower on the scale the less willing creditors are to lend money to a country – either directly or by buying government issued bonds (long term debt instruments). Or, they may be prepared to lend money, but at much higher interest rates to make up for the additional risk that they will take on board. These punitive rates mean that SA’s borrowing costs escalate, resulting in a higher portion of its revenues (taxes) going to pay back debt (at the expense of spending on social services or infrastructure).

But that’s not the only consequence. The thin line differentiating between Investment Grade and Sub-Investment Grade (or Junk Status) is stark in its consequences. Many international investment funds – including sovereign funds – have investment rules that strictly dictate where their managers may or may not invest. Sub-investment graded economies are off limits; the managers have no choice, no matter how high the potential yield.

Worse: As soon as a country’s investment rating is confirmed by more than 2 credit ratings agencies as sub-investment grade, these funds have to actively dis-invest from that country. These are massive funds; whilst only a small percentage of their overall portfolio is invested in Emerging Markets, and an even smaller fraction in SA, their withdrawal translates into billions of dollars in capital outflows. The latter has the potential to seriously impact the value of the currency, which in turn feeds into a cascade of other negatives for the country: imported inflation, higher interest rates, restricted economic growth, and etcetera.

The knock-on effect of a sub-investment grade rating also immediately hurts the private sector. South Africa’s banking sector is well regarded as being conservative and well managed by the SA Reserve Bank. However when the country’s rating is downgraded, the banks are immediately (automatically) marked down too. This makes it more expensive for these banks to borrow from abroad too – costs that are invariably passed through to local consumers.

But this is not simply a switch from Investment Grade to marginal Junk status; the ratings can easily drop further, in a downward spiral that eventually leads to much lower rungs, eventually reaching Debt Default rating. At that point the last-resort lender becomes the IMF, and such bail-out funds come with enforced austerity from which a country either slowly recovers over generations, or sinks into basket-case turmoil (Zimbabwe, Venezuela, Haiti).

SA is not the only Emerging Market country with a sub investment grade rating. It has simply joined others in the junk-bond club (including BRICS partners Turkey, Brazil and Russia). But can the country recover? Can it climb its way back up the ladder to Investment Grade?

Yes it most definitely can. But it will need to take the kind of economic reform medicine that is deeply unpopular with the political alliance that makes up the ruling party: the ANC, the SA Communist Party and the trade unions. And even if the new leadership does find the backbone to radically change its downward trajectory, it is not something that will happen overnight. With all the goodwill shown to it after the dawn of democracy it still took SA from 1994 to 2006 to reach BBB+ status. This time it is going to be harder, with much less goodwill in the air.

So where does this leave the South African Expat with funds back in SA? That will depend on one’s personal view of upside versus downside. The Rand remains volatile, seeming to nervously hang in the wind waiting for either good news (international commodity prices, improved local economic conditions, a turn-around in corruption, etc.) or bad news (confirmed junk status, recession, growing debt, dwindling tax revenues, etc.). There is little consensus amongst economists and financial commentators. Some project a range of between R14 and R16 to the US dollar, others point out that much worse is possible.

Each investor needs to evaluate upside versus downside, and determine what level of risk they are prepared to endure. Very much like a private ratings agency…