Ratings cut? South Africa's local bonds already trade as junk

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By Sujata Rao and Karin Strohecker

LONDON, Nov 23 (Reuters) - South Africa's deeper descent into junk-credit territory and ejection from major global debt indexes seem to be accepted as a done deal before they actually happen, bond yields and default insurance costs suggest.

Africa's most industrialised country risks downgrades on its local currency debt rating from Moody's and S&P Global on Friday. Both rate it on their lowest investment grade rung of Baa3/BBB-minus.

A cut by both agencies would see South Africa's $125 billion debt market lose its place in the World Government Bond Index and the Barclays Bloomberg index. That would in turn force index-tracking and rating-constrained funds to sell more than $10 billion in debt, analysts have predicted.

But it would only confirm the view, long held by seasoned emerging bond investors, that the once-prized but inexorably deteriorating emerging market deserves to be treated as junk.

Plagued by corruption, moribund growth, refusal to embrace reform and - most recently - by a budget deficit blowout revealed by Finance Minister Malusi Gigaba, South African 10-year bonds yield over 9 percent.

That is well above Indonesia, Romania or Hungary, which carry the same rating from Moody's.

The cost of insuring exposure to South Africa's debt via credit default swaps (CDS) is also higher than peers with the same Moody's rating. Its five-year CDS spread is double Indonesia's for instance.

"If you look at external debt spreads and CDS, that's pretty much bang on where the average BB credit trades. It's trickier to compare on the local side, but nonetheless it's cheap... real yields are among the highest in EM," said Paul Greer, senior trader at Fidelity International.

A CDS-based model from S&P Capital shows markets pricing a two-notch downgrade, treating South African foreign debt - downgraded to junk earlier this year - as if it were BB- rather than BB+, as this graphic shows:

Correspondingly, South African dollar bonds pay an average premium of 287 basis points over Treasuries, while Indonesia pays 173 bps.

"It feels like time has run out," said Sailesh Lad, senior portfolio manager at AXA Investment Managers who is "underweight" South African debt in his portfolio.

"The budget tells you the debt dynamics are on a worsening trend, the finance minister has not delivered what was anticipated."

Gigaba in October slashed growth forecasts and hiked his budget deficit to 4.3 percent of gross domestic product from 3.1 percent in April, pencilling in a big rise in borrowing.

For Lad, this means little policy change can be expected after the ruling ANC party's December conference that will vote to replace its scandal-plagued leader Jacob Zuma.

"Whoever wins in December, the ANC has already dictated what policy is going to be... Are you going to see wholesale change? I don't think so," he said.

Cristiana de Alessi, a portfolio manager at BNP Paribas Asset Management, said most of the risks cited by agencies for the sovereign rating had already materialised. For her, the turning point came in March when Zuma sacked respected finance minister Pravin Gordhan without warning.

"The ratings agencies always talked about the strength of the institutions, and you can see a marked deterioration in the Treasury over the past six months or so," she said.

However, de Alessi and Greer both reckon South African bonds could be attractively valued if a double-downgrade caused a huge selloff. Inflation-adjusted 10-year yields currently are around 4 percent and the rand is relatively cheaply valued, they said.

The local pension and insurance industry especially could step in if foreigners, who currently own half the bond market, started bailing out.

Fund managers surveyed by Bank of America Merrill Lynch earlier this month said they could be enticed to buy if 10-year yields were between 9.50-10.00 percent.

"For every seller there is a buyer dependent on the price and the yield, and there are levels definitely where local managers will see some value," said Melville du Plessis who oversees a 150 billion rand ($11 billion) portfolio at Sanlam in Johannesburg. ($1 = 13.9001 rand)

(Reporting by Sujata Rao and Karin Strohecker, additional reporting and graphic by Marc Jones in London, additional reporting by Mfuneko Toyana in Johannesburg; editing by John Stonestreet)