At the end of March, amid the chaos of the lockdown, the rating agency Moody’s downgraded South African sovereign debt to non-investment grade – or junk status. As the last rating agency to do so, it means that South African government bonds will no longer be included in the World Government Bond Index (WGBI) from the end of April. Shortly after the Moody’s downgrade, ratings agency Fitch further downgraded South African government debt to two notches below investment grade.

But what does this mean for South Africa and for investors?

From a government perspective it means borrowing money has become more expensive, as the government will have to borrow at a higher interest rate. It is similar to an individual applying for a loan with a poor credit record – they will be charged higher interest rates because they present a higher risk.

More expensive debt means more of South Africa’s tax revenue will have to be used to pay interest, leaving less for government spending on essential goods and services.

Banks or corporate debt may not have a credit rating higher than that of the government. This means banks will pay more for funding which could have a knock-on effect on the interest charged for loans. However, it could be beneficial for savers as deposits become a cheaper source of bank funding and banks will compete more aggressively for those deposits.

Downgrade already priced into currency

Finally, we could see an increase in inflation as the rand weakens. As foreign investors sell South African bonds, so the demand for rands decreases and the currency weakens. This results in import inflation. As much as one-third of the South African economy is made up of imported inputs or imported final goods. It could take as long as nine months for this imported inflation to pass through into the economy. Hopefully South Africa has been spared the full impact as the USD oil price has fallen dramatically as a result of the global lockdown.

Stanlib economist Kevin Lings explains that the currency was already under pressure before the downgrade, as the Moody’s decision was widely expected.

“The currency was already about 20% – 25% undervalued before the downgrade,” says Lings.

The unknown is what will happen at the end of April when South African bonds are removed from the WGBI. Normally the index is reweighted at the end of each month, in which case South African bonds would have been removed from the index at the end of March. Due to the uncertainty and market volatility, a decision had been made not to re-weight the index until end of April. That means fund managers who track the index will be forced to hold SA bonds until the end of April. Then they become forced sellers which could see further pressure on the rand.

Lings says that despite the relative attractiveness of South African bonds, index trackers will have no choice but to sell. Estimates are that around R60bn will leave South Africa.

The one upside to the downgrade is that investors who specialise in junk bonds would now be able to invest in South Africa’s bonds.

“When bond yields pick up as they do, they become attractive and some investors will return to the market depending on their risk appetite. But this will depend on their views on the spread of the virus and the impact on the global economy,” says Lings who adds that opportunistic buyers have already started to enter the market as they are buying not only a high interest rate but at a very weak currency which means the downside risk on the currency is limited.

Lings says investors will be making educated guesses at this stage, but a lot will depend on the outcome of the spread of the virus. Most emerging markets will not be able to manage a major outbreak and may need to turn to other sources of funding such as the IMF.

Lings says the current yields from the bond market are making it attractive for local investors who can lock in returns of 11% per annum in a relatively safe asset class. In fact, many local asset managers have been taking advantage of these yields to add to their clients’ portfolios.

Default unlikely

Lings believes the likelihood of a government default (not repaying its debt) is very low as South Africa still has options available for funding such as the BRICS Bank and the IMF.

“A default is usually a result of either an ideological approach of just ignoring a payment or a lack of planning around meeting a debt repayment, especially when the loan is due,” says Lings.

It’s similar to the situation of an indebted household, where the consumer chooses to ignore debt repayments or where they have not created a budget and prepared for the debt repayments.

Lings argues that with the current leadership in South Africa, default is not likely. There is no ideological stance of not paying back borrowed money and National Treasury has managed debt repayments and capital raising in a well-managed fashion. Finance minister Tito Mboweni has also made it clear that the government would not be averse to approaching other institutions such as BRICS and the IMF for support.

However, South Africa is on a very challenging path, with estimates that our economy will contract by around 5%. The ability of government to raise revenue through taxes will be severely constrained and there will need to be significant spending cuts.

The focus will need to be on getting the South African economy growing and making use of a weaker rand to boost exports.

This article first appeared in City Press.