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Risk And Opportunity

 The threat of a downgrade has been hanging over the market for nearly a year, ever since S&P put South Africa on negative watch in December 2015. With the country’s sovereign rating only one notch above sub-investment grade, the next step down would be into ‘junk status’.

This has worried many investors, as the obvious question is what they should be doing with their portfolios. How do they manage the risk of a potential downgrade?

For Ian Scott, the head of fixed income at PSG Asset Management, however, this question should always be asked alongside another: what if South Africa isn’t downgraded? The outcome, he argues, is not guaranteed and therefore investors should be seeing not only the risk, but also the opportunity.

“What’s important to think about is that the downgrade is already reflected in South African bond pricing,” says Scott. “The country’s offshore credit spreads are trading in line with other countries that are already in junk status like Brazil, Russia and Turkey. Nobody knows what the market will do if we are downgraded, and there will probably be a knee-jerk reaction, but a lot of that negative news is already reflected.”

This means that the risks, and therefore the opportunities, may not be the obvious ones.

“The important thing is that a downgrade doesn’t mean a default,” Scott says. “South Africa’s debt metrics by global standards are not that onerous. Our debt-to-GDP ratio is only around 50%, and only 9% to 10% of our debt is offshore. If you look at our peer group, their numbers are way above that.”

He argues that an objective assessment of the country’s fundamentals suggests that there is a low probability that South Africa will default on its debt.

“If you can put the political noise to one side, for our peer group we are still in a good fundamental space,” Scott says. “The possibility that South Africa will not pay its debt is very low. So if you think that we have high yields, a strong capital market, and good banking system, that’s not a bad environment.”

He believes that foreign investors are seeing this opportunity more than locals.

“If this was a country where foreigners felt that they couldn’t be sure of getting their money back, why would they be coming into our market?” Scott asks. “When government recently placed $3 billion in offshore bonds, the placement was three times over-subscribed.

“That doesn’t indicate that foreigners feel that they won’t get their money back over the next ten years,” he says. “Yes, fears around the political situation do make it a much more cloudy situation, but within that is probably where the opportunity lies. We don’t know what will happen, but if you sit in assets that already reflect that negative pricing we think that’s an opportunity.”

Scott therefore warns investors against premising all their decisions on a single outcome. Building a portfolio that assumes that a downgrade is a certainty places you at significant risk.

“There is a big binary danger in having only one view in your portfolio because if that doesn’t materialise it could have a very negative effect if the opposite actually happens,” he says. “You don’t want to take one way directional bets. In the volatile world we live in, that is quite a dangerous thing to do. Diversification in a portfolio is prudent.”

This does mean taking a more nuanced view of risk. The downgrade isn’t the only risk out there, and it may not even be the biggest one.

“Is it that risky to buy government bonds when a downgrade is already reflected in the prices?” Scott asks. “At PSG, we think that when bond yields are low, that’s when you have the biggest risk. When yields are high and there is a lot of fear and uncertainty in the market that is when we see opportunities.”

He points out that last December at the time of Nenegate, ten year government bond yields spiked above 10%. This was a time of great fear in the market. However, PSG saw that as a buying opportunity because a large amount of uncertainty was being priced in.