Bond problems possible over South Africa woes

Institutional investors and money managers who worked to take advantage of opportunities in emerging markets debt could become forced sellers of South African bonds, as the reality of the country's downgrade by credit rating agencies sets in.

Ratings agencies Standard & Poor's and Fitch Ratings in early April downgraded the country's foreign currency debt to BB+, below investment grade, from investment grade, just days after South African President Jacob Zuma sacked Finance Minister Pravin Gordhan, along with eight other members of the Cabinet.

The downgrade is not just a problem for the country and its ratings: some pension funds might be forced to exit any exposure to the country, as their investment principles and guidelines might prohibit owning debt with below-investment-grade ratings. The downgrade also means investors with exposure to emerging market debt, particularly via indexes such as Citi's World Government Bond index, are facing the prospect of losses due to the heavy weighting of South African bonds, according to sources. As of March 31, the weighting of South Africa in the WGBI was 0.43%.

“We think there could be about $2 billion forced selling on the hard currency side for (South Africa sovereign bonds) post the downgrade. The long end part of the sovereign curve was quite popular with Asia (life insurers), which are quite ratings-sensitive, thus the selling pressure could be more concentrated on that side,” said Ray Jian, portfolio manager, emerging markets sovereign bond at Pioneer Investments in London.

Jan Dehn, head of research at Ashmore Group in London, reiterated the impact of heavy losses. “An investor reacting to the downgrade now (has) probably (lost) 11% on the currency (moves) since March,” he said.

Active and specialist emerging markets managers, however, will have fared better, Mr. Dehn said. “(They) were probably underweight South Africa already in the period leading up to the downgrade as the response from rating agencies was delayed.”

As much as 36% of South Africa's local currency debt, $1.7 trillion, is estimated to be in the hands of foreign investors. Sources warned that should Moody's Investors Service follow the lead of S&P and Fitch, outflows could begin to hit the country at a serious pace. Moody's put South Africa on review for downgrade on April 3. A decision is expected in the next 30 to 90 days, the rating agency said.

Sources also agree that crossover investors — those with developed markets exposure but who also invest at the margins in emerging markets local currency debt for diversification and income purposes — will be hurt more than dedicated emerging market managers.

Emerging market local currency sovereigns with 6% estimated yield, 1.5 years duration and 4% inflation, such as South Africa, were considered a desirable destination for the money of many global investors, unable to find yield in other parts of the world, according to sources.

Yields on both external and local currency debt increased in the immediate aftermath of the downgrades, said Kevin Daly, senior investment manager at Aberdeen Asset Management in London.

Following a downgrade from Fitch on April 7, the yield on a 10-year benchmark U.S. dollar bond increased a further 20 basis points to 5%, Mr. Daly said, in line with the move on the 10-year local currency bond.

Mr. Jian said: “We have been underweight South Africa for quite some time, because we felt the market has completely priced out the political risk, which would only intensify as we approach to the December (African National Congress) conference.”

All eyes will also be on the impending decision from the third global ratings agency, Moody's. The country has retained investment-grade status on two local currency ratings, Baa2 by Moody's and BBB- by S&P, after losing its investment-grade local currency rating from Fitch, which now rates it at BB+.

Moody's is expected to downgrade South Africa's sovereigns and local currency by one notch in its ongoing review — expected to last up to three months. That would “still leave it in investment-grade territory at Baa3,” said Tim Ash, emerging markets senior sovereign strategist at BlueBay Asset Management in London.

“Markets have taken the move relatively in their stride though — and the bigger move that many people expected has not been forthcoming. This reflects the supportive global backdrop, and general bid for emerging markets, plus stronger global growth data and still supportive global financing conditions. There may also be a willingness to give the new Zuma team some time to prove themselves,” Mr. Ash said.

Even if international investors are forced to pull out of the country, South Africa-based pension funds could end up buying the bonds.

Adre Smit, senior policy adviser at the Association for Savings and Investment South Africa, based in Johannesburg, said South African pension funds' rand exposure to government bonds has increased more than 60% since 2011, to 1.15 trillion rand in 2016. The exposure as a percentage of total assets has remained fairly constant at 15.6% in 2011, and 15.9% in 2016.

“This would indicate that funds are investing a consistent percentage of their new cash flows into South African government bonds annually,” Mr. Smit said.