Moody’s decides: Has a downgrade to junk already been priced in?

Chris Holdsworth, investment strategist at Investec Wealth & Investment, discusses the Moody’s statement on South Africa’s credit rating that is due to be released on 29 March.

Historically, downgrades have proven to be a buying opportunity as markets tend to price in the downgrade in advance. Downgrades also usually focus the minds of governments to institute required reforms.

Moody’s is the only rating agency that has not downgraded South Africa to sub-investment grade; so a downgrade could affect South Africa’s inclusion in a number of global bond funds and indices.

Moody’s is unlikely to downgrade South Africa this time around, but could put South Africa on a negative outlook, which would mean a subsequent downgrade if the issues raised are not addressed. Among the most pressing of these is the Eskom crisis.

However, he also points out that bond markets are already pricing South African government bonds at sub-investment grade. We are priced at worse than Brazil, which is already sub-investment grade.

It’s a similar picture in the currency market (the rand is weaker against its emerging market peers) and also in the credit default swap (CDS) market, which measures the cost of insuring against default.

A downgrade can be a buying opportunity

If a downgrade does happen, it’s not all bad news. Based on analysis of sovereign downgrades over the years, the actual downgrade has been a buying opportunity: credit default swap spreads typically come down over the subsequent six months.

This sounds counter-intuitive, but there is some logic to it. Markets tend to price in the downgrade in advance, while the downgrade usually focuses the minds of governments to institute reforms that will address their weaknesses. 

Do ratings really matter?

Given the above, one has to ask: do ratings really matter? They do, simply because a number of global bond indices (which are tracked by passive funds) require a country to have an investment grade rating to be included, while many actively managed funds only invest in investment grade bonds, which indicates there would in all likelihood be an outflow in the event of a downgrade.

Similarly, many corporate bond issuers (including banks) would be affected. The Reserve Bank has been conducting stress tests in this regard.

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