Traders downplaying SA credit risk should heed Turkey

The erosion of Turkey’s creditworthiness is a warning signal for South Africa, and investors are ignoring it, according to Informa Financial Markets.

The cost of insuring the country’s debt against non-payment dropped to the lowest in 13 months this week, even as a funding crisis at Eskom strains government finances while the economy struggles to recover from the worst quarterly contraction since the 2008 financial crisis.

Moody’s Investors Service, the only major rating company still to assess South Africa at investment level, is reviewing its stance in November. Last month, Moody’s cut Turkey’s rating deeper into junk citing, among other factors, erosion of institutional strength and the government’s inability to implement measures to revive the economy. Similar problems also plague South Africa, said Christopher Shiells, a London-based emerging-market analyst at Informa.

“Turkey’s credit-rating troubles throw an uneasy light on South Africa,” Shiells said. “Moody’s rationale for downgrading Turkey should be of concern for South Africa watchers as these are problems that beset South Africa.”

South Africa’s economy hasn’t expanded by more than 2% a year since 2013, and endured recessions in 2009 and 2018. There’s a chance it may be headed for another after the first-quarter contraction. Turkey’s economy emerged from a recession in the first quarter.

Yet the cost of five-year credit-default swaps - insurance against a default - fell to 163 basis points on Wednesday, more than 200 below Turkey’s. That suggests traders aren’t hedging for the possibility of a downgrade.

“There could be a widening out in South African spreads in the build-up to the November rating decision if economic fundamentals continue to deteriorate,” said Shiells. The CDS spread could “blow out” as much as 200 basis points in the event of a downgrade, he said.

The blow-out could extend to bonds. Benchmark government bond yields are around the lowest since April 2018, leaving plenty of scope for a reversal in the event of a Moody’s downgrade, which would spark a sell-off by funds that track investment-grade indexes.

And while the country’s foreign-currency debt is already considered junk - with ratings below investment level at S&P Global Ratings and Fitch Ratings - that hasn’t deterred investors. The bonds have returned 12.3% this year, beating the average return of 11% for the 629 member Bloomberg Barclays EM Hard Currency Aggregate Sovereign Total Return Index.

The country’s 2048 securities are the top performers in BB category, with a return of 20%. The yield on the debt is at the lowest since the notes began trading in May 2018.

A downgrade for the local-currency bonds to junk would have a “spillover” impact on the hard-currency notes, said Trieu Pham, a London-based emerging markets strategist at ING Bank NV.

“With the external backdrop dominating, market pricing indeed doesn’t factor in the risk of a Moody’s downgrade,” Pham said. “A negative surprise would see an initial knee jerk reaction on the on the bonds.’’

South Africa’s currency, too, shows little sign of investor anxiety, with the premium of options to sell the rand versus the dollar over those to buy it at the lowest level since May 2018. That may haunt some traders come November.