South Africa: It's Time To Sort Through The "Junk" In Your Debt Documents

Following downgrades by ratings agencies Standard & Poor's ("S&P") and Fitch in April 2017, Moody's cut South Africa's foreign and local-currency ratings to investment grade Baa3 with a negative outlook on Friday, 9 June 2017.

On 2 June 2017, S&P reaffirmed its 3 April 2017 decision to downgrade South Africa's foreign currency debt to "junk status" (BB+) (the colloquial term given to a non-investment grade rating), and retained a negative outlook on South Africa, saying that "weak economic growth and political uncertainty continued to pose risks to the rating". Following shortly after this decision, S&P further downgraded South Africa's banks to non-investment grade (BB+). This was in line with its rating of the country, as banks cannot be rated higher than the country's foreign currency sovereign credit rating "because of the likely direct and indirect influence of sovereign distress on domestic banks' operations, including their ability to service foreign currency obligations", S&P said in a statement on 5 April 2017.

On 7 April 2017, Fitch downgraded South Africa's unsecured foreign currency and local currency bonds to non-investment grade.

One question on everyone's mind should be "what is the impact of the downgrade on my debt/loan documents?". It is a good time for institutions to look at their debt documents to assess any such impact. Below is a list of key points to keep in mind (this list is non-exhaustive and may need to be adapted depending on the facts of the matter):

Bonds/notes programmes

Issuer considerations:

  • a credit rating downgrade could (in a worst case scenario) trigger an event of default clause (with the risk that this could trigger cross-default provisions in other funding documents);
  • a credit rating downgrade could result in a forced redemption event;
  • a credit rating downgrade could trigger an interest rate "step up" required by investors as a risk premium for the potentially volatile market;
  • a credit rating downgrade could result in increased reporting covenants. The reporting covenants are an increased administrative burden, which, if not complied with, may trigger an event of default; and
  • if an issuer wants to roll over notes currently in issue or issue new notes, the adverse credit rating could result in the notes requiring a higher interest rate (due to the increased risk premium), thus being more expensive for the issuer.

Investor considerations:

  • an investor's mandate may be such that it can only invest in investment grade notes. As two rating agencies have downgraded South Africa to junk status, this may mean that certain international investors will have to divest from South Africa or risk breaching portfolio mandates. This could result in a sell down of the notes in issue which will flood the market and drive the price of the notes down. Additionally, this may result in a sell down of the rand, which will have the knock-on impact of causing bond yields to rise. Increases in bond yields could potentially lead to short-capital losses for sellers of the bonds and increased volatility notwithstanding that bonds are typically seen as stable investments. If South African bonds are seen as riskier, investors will require additional compensation to offset the additional risk.

Loans

  • in standard Loan Market Association-style loan agreements, there is likely to be a "material adverse effect" ("MAE") clause that deems a loan to be repayable if a circumstance or event has, or is likely to have, a material adverse effect on the borrower's ability to repay the loan by adversely affecting:

    • the borrower's ability to comply with its loan obligations;
    • its business or condition (financial or otherwise); or
    • the enforceability of the finance documents.
    If the MAE event occurs, the lender may accelerate the loan and demand repayment. A ratings downgrade may be included in the loan agreement as a MAE event, thus triggering an earlier loan maturity date.
  • similarly to the MAE clause, a ratings downgrade could trigger a material adverse change event of default, which would have corresponding consequences to those set out above in relation to the MAE clause.
  • it is important to note that if a borrower commits an event of default under any one loan agreement, this is likely to set off a number of cross-default clauses across other loan agreements and bond documents.
  • the borrower's credit rating may affect the margin rate applicable to the loan repayments; ie, it may be such that the loan makes provision for changes to the borrower's credit rating directly affecting the applicable margin/interest rate. The lower the borrower's credit rating, the higher the margin payable and vice versa. Where the borrower is a parastatal, South Africa's credit rating may be used to determine the margin payable.
  • additionally, there may be a "changes in rating" clause in a loan agreement, which may specify that if the borrower's credit rating in respect of its unsecured and unsubordinated foreign currency long-term debt falls below an investment grade rating, the borrower shall either deliver an irrevocable and unconditional guarantee to the lender or immediately prepay in full any loan obligations then outstanding.
  • in the case of a loan to a parastatal entity, the ratings downgrade may give rise to the need to provide a government guarantee to secure the obligations of the borrower. This could potentially affect borrowers such as Eskom, SANRAL, ACSA and PRASA, all of which are state-owned entities.
  • the information clause contained in a loan may require a borrower, promptly upon becoming aware of same, to notify all finance parties of any change to a credit rating assigned to the borrower, or South Africa (in the case of a parastatal).
  • the ratings downgrade could give rise to an obligation on the part of the borrower to provide additional reports and/or more regular financial reports to lenders.

International Swaps and Derivatives Association Master Agreement

  • similarly to the debt documents noted above, a credit rating downgrade could potentially trigger a termination event under the International Swaps and Derivatives Association Master Agreement; alternatively, it could trigger an event of default; and
  • the credit rating downgrade could trigger the need for additional collateral to be posted.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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