Bracing for a downgrade: what you need to know

By Nedgroup Investments

2020 has started with a bang – and not necessarily in the positive sense.

Given recent domestic concerns around the continuing out-of-control funding requirements for most SOEs and the Government’s lack of urgency in addressing these problems, combined with economic growth forecasts of below 1%, it is likely that Moody’s will look to downgrade South Africa to junk status within the next few months.

With all this negative sentiment around – it’s understandable that investors are concerned. However, the crucial thing is to stay calm and rational and be in full possession of the facts before making any investment decisions.

Much has been said about the fact that the downgrade has already been priced into the market and that any major sell off of RSA bonds, as a result of South Africa falling out of the Citi World Govt Bond Index (WGBI), will be matched by speculative buyers attracted by our relatively high bond yields. This would then in turn reduce any major spikes in yield or weakness in the Rand. We, however, are not as convinced that the short-term effects will be as muted as many of these market commentators are suggesting. 
 
Index funds have grown substantially over the years and there is not a lot of data available on the effect on bond yields when countries leave the index. So it is anyone’s guess as to how the market may react to a large amount of bonds being liquidated in a short space of time and this could put strain on the financial system.  

Hence, we as fund managers of the Nedgroup Investments Cash Solutions fund range, have maintained a relatively conservative approach to credit and liquidity within the funds in anticipation of any market or banking system stress. Currently, the funds collectively hold in excess of 90% exposure to the big 5 banks in South Africa (Absa, Nedbank, Standard Bank, FirstRand and Investec) – the majority of which is held in negotiable certificates of deposit – probably the most liquid instruments available, and well diversified across all maturity bands. This is the most conservative, from a credit and instrument-type perspective, that the funds have ever been over the last 10 years.

In addition to the conservative credit nature of the assets, we have also increased the levels of available liquidity within the funds, in anticipation of any major banking system stress should the downgrade create a liquidity squeeze or more financial market disruption than the market seems to be expecting or pricing in. The current level of available cash in the funds is near historical highs, but we feel that this is prudent under the circumstances.

Overriding all of these specific steps we have already taken to prepare for any potential market volatility, is our philosophy of holding mainly floating rate assets (we currently hold 100% in assets which reprice in 3 months or less) which largely immunise the portfolio against interest rate volatility as they have very low modified durations and do not fluctuate in value in the same way that fixed-rate assets do when interest rates move.  

A final observation is that whether investors hold their money in a money market or enhanced money market type fund, or in a big South African bank call account, the impact of any market disruption would be similar as the funds’ exposures are largely to these banks anyway. However, the call accounts currently yield up to 2% less than the such funds, and these funds hold a spread of exposures as opposed to all credit risk being to one entity. We would suggest that it is preferable for investors to have diversified exposure to the big 5 banks via a fund. 
 
Taquanta Asset Managers, Managers of the Nedgroup Investments Cash Solutions fund range