Since Fitchs decision to downgrade South Africas long-term foreign currency and local currency rating to sub-investment grade and S&Ps similar move on the sovereigns foreign currency rating in April, there has been much speculation about the impact of the downgrade on citizens and the broader economy.

With Fitch now reaffirming that rating, S&P set to announce its decision on reviewing its local currency rating of South Africa this week and Moodys announcing the sovereign rating after review for possible downgrade early in June, the outlook remains largely uncertain.

S&Ps review is particularly critical in the short term due to its impact on holdings of South African government bonds on global indices. Research suggests that the downgrade to sub-investment grade of the local currency rating by two or more agencies will trigger billions in capital outflows as foreign investors in local bonds are forced out of sub-IG debt by mandate restrictions and/or benchmark rules.

The worst case scenario, which is looking increasingly likely, is S&P and Moodys joining Fitch in downgrading the local currency to sub-IG. South Africa would, in that case, be removed from the World Government Bond Index (WGBI), which would result in the estimated selling of $8.8 billion or approximately R114.4 billion, as well as fall out of the JP Morgan Treasury Index which would lead to the forced selling of $4 to 5 billion (around R52 to 65 billion).

Regardless of the final outcome, the impact is considerable and will affect the balance of supply-demand in the local bond market resulting in upward pressure in yields. The returns on South Africa's retirement fund investments, which are long-term holders of South African government bonds, will be adversely impacted by these developments in the short- to medium- term because we expect real bond and nominal bond yields to come under pressure; the exchange rate of the rand to be weaker in the short-term owing to outflows and generally negative sentiment around downgrade, weakened growth outlook and increasingly volatile political backdrop. However, it is critical to evaluate the historical backdrop leading to the countrys downgrade and how it compares to other countries that have been downgraded to sub-IG worldwide in order to formulate risk mitigation steps and techniques for retirement fund managers, principal officers and trustees to protect their clients investments as effectively as possible.

Broadly, South Africa enjoyed its best rating between 2008 and 2010 and the countrys position and performance has been deteriorating since then as fiscal ratios indicate a weakening state of affairs due to a combination of low growth, slowing GDP per capita growth, rising government debt, increasing political uncertainty, rising socio-economic pressures and overall inequality.

A downgrade in light of these factors may therefore seem a logical next step, and South Africa is by no means the first or only country to have been downgraded, even though there are not a wealth of case studies on local currency downgrades to take key learnings from.

The World Bank recently conducted a global study of 20 countries that were downgraded to sub-investment grade between 1998 and 2015, and found that asset allocation shifted markedly as a result of financial instruments being excluded from indices such as WGBI or the JP Morgan Treasury Index, for instance. Added to increased risk premiums and borrowing costs and a curtailed ability to borrow for the downgraded countrys firms, there is a markedly decided cap on growth and returns on investments.

Because the cost of investing is higher and the returns are lower, many fund managers make the choice to disinvest in local assets and countries struggle to grow out of the downgrade. On average, it takes seven years to win back investment-grade status and that is after intensive tightening up of fiscal and monetary policies in the country but there are a few exceptions.

A country that serves as a beacon of hope in being able to beat the downgrade curve is Latvia. It was downgraded in 2009 after a consumer credit and investment boom that followed its inclusion into the Eurozone collapsed in 2007. The collapse was further escalated by the Global Financial Crisis of 2008. Together, these events led to sharp falls in GDP and the deterioration of fiscal accounts. A resolute government, eager to maintain the currency peg to the euro, allowed for internal devaluation to take place resulting in cuts in government expenditure and investments, reduction in government employees, increased emigration, and a drastic rise in unemployment. The economy rebalanced through tighter fiscal austerity measures and monetary tightening which gave confidence back to investors and this in turn attracted capital investments back into the country. Private sector employment rose and was much higher than government, export sector was growing due to increased productivity of existing labor and the general optimism induced local demand. Notable improvements in budget balance, growth and short-term rates were evident barely three years after the boom-bust and the country was consequently upgraded back to investment grade in 2012.

What this indicates is that there is the potential for South Africa to regain its investment grade with concerted efforts in tightening up and implementing policies that will stabilise the socio-economic and political volatility that led to the downgrade.

Nevertheless, we can reasonably assume that the impact of South Africas downgrade to sub-investment grade and expected forthcoming downgrade will continue to make itself felt for the medium-term at the least, especially in the pension and retirement sphere as it is a long-term savings vehicle and typically sees investment in either nominal or inflation-adjusted bonds and equities.

The investment case for nominal bonds is relatively stronger than inflation-linked bonds, as we expect real yields to price higher in an environment of increased uncertainty, lower inflation and growth outlook. A weaker Rand outlook increases the case for offshore diversification and/or increased exposure to rand-hedge versus cyclical stocks in a defensive equity positioning; but overall equity exposure ought to remain underweight as we do not expect double digit returns in the next twelve months from the asset class under these economic conditions. However, equities post downgrades have not shown too much sensitivity on the downside but mild aberrations and below par growth rates. Looking ahead, equities are expected to hold but fund managers should not expect double digit growth and on a risk-adjusted basis nominal bonds will be relatively better investments. The fact remains that the downgrade has introduced real risks that have led to negative impacts on varying classes of investment, including equity and bond prices. This has widely led to, and will continue to result in, defensive and offshore pension and retirement fund asset allocation, with subdued return expectations.

As such, caution remains the most advisable course of action in the retirement and pension space. It is necessary for fund managers, principal officers and trustees alike to pay close attention to risks and opportunities alike in the ever evolving investment landscape in order to best mitigate risks and manage returns.

Ntobeko Stampu works at Barclays Africa Wealth, Investment Management and Insurance

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The downgrade and retirement funds: what does it mean? - African Independent