Anticipating the fallout from South Africa’s ratings reviews

June 10, 2014

South Africa is due ratings reviews this Friday. Chances are that the Standard & Poor’s agency will cut its BBB rating by one, or possibly even two notches.  Another agency Fitch has a stable outlook on the rating but could still choose to downgrade the rating rather than the outlook. What will be the damage?

There is undoubtedly a link between ratings and bond prices.  So a one-notch ratings downgrade tends to lead to roughly a 20 percent increase in bond yield spreads and credit default swaps (instruments that are used to hedge against default), according to calculations by JPMorgan. But in South Africa the lower credit rating may already be already reflected in asset prices — Panama, Brazil, Colombia, Philippines, Uruguay, Indonesia, and Romania carry lower sovereign credit ratings but boast lower CDS and dollar bond yield premia over Treasuries.  Russia and Turkey have lower average ratings than South Africa but their debt and CDS spreads  are roughly on the same level.

So a ratings cut is unlikely to trigger huge outflows from South African debt markets, says JPMorgan, which runs the most widely used emerging bond indices. In Brazil for instance, a well-anticipated  downgrade back in March did not lead to significant cash outflows from its markets, JPM points out:

The current relationships between spreads and ratings do not necessarily imply another step wider in South Africa’s spreads until it is firmly sub-investment grade (not J.P. Morgan’s base case).

Secondly, even after a downgrade to BBB-, South Africa would still be rated investment grade, so investors will not be required to sell their holdings.  On local currency debt, South Africa is rated A- from S&P so a 1- or even 2-notch downgrade should have no technical impact the bank argues.

Not to say all is well. JPM analysts advise clients to stay underweight South Africa, noting:

The likely continuation of the ratings downgrade process confirms the slow credit deterioration in the country…simply put, South Africa’s fundamental position is not showing signs of improvement in the way Indonesia and Turkey are, given their stronger external rebalancing and higher growth rates.

This was borne out by data on Tuesday that show the country’s  manufacturing output fell by 1.5 percent year-on-year in volume terms in April after a revised 1 percent expansion in March. And inflation is above the central bank’s 3-6 percent target band, meaning the central bank could raise interest rates, further crimping growth.

Societe Generale analyst Regis Chatellier reckons South Africa will remain investment grade for at least 12 months more, given the strength of its institutions and the depth of its markets.  He agrees with JPM that a huge selloff is unlikely to follow a ratings downgrade:

South African global bonds have largely underperformed in the last four weeks, with investors anticipating the downgrade. After the (likely) downgrade of S&P, we expect the risk on the credit to be fully priced, and the performance.. should then stabilise.

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