Despite the meaningful risks looming over South Africa’s banking sector, the current combination of attractive dividend yields and relatively cheap valuations presents attractive prospective medium-term returns for investors in local bank shares, despite fairly muted earnings growth expectations in the low- to mid-single digits, according to Craig Butters, equity portfolio manager and banking sector analyst at Prudential Investment Managers.

Banking stocks fell sharply in December 2015 on the back of the large jump in bond yields in reaction to the surprise firing of Finance Minister Nene, to levels well below their historic valuations. They have remained under pressure due to the increased risk of a downgrade of South Africa’s sovereign foreign currency credit rating to non-investment grade (or “junk”) status. “Banking shares are pricing in this downgrade risk, and until there is clarity on this – perhaps in the December round of ratings agency reviews – we see limited scope for the banks’ valuation multiples to rebound back to historical levels,” says Butters. “Currently, banks are trading at a substantial discount of 35% to the overall SWIX index (on a forward price-earnings basis), compared to an average 13% discount since 1990.”

Depending on the extent of a likely weakening of the rand on news of a downgrade to junk status, the South African Reserve Bank (SARB)’s monetary policy response could have a profound impact on the banking sector, he explains. To the extent that a weaker currency results in increased actual or expected inflation, the response by the Monetary Policy Committee in hiking interest rates will be key.

On balance, he points out, gradual and measured interest rate increases are positive for banks since they receive higher interest income – as we have seen so far in the SARB’s current rate hiking cycle. The gain in interest income generally outweighs the rise in bad loans as more people are unable to repay the higher interest. However, if the SARB responds by implementing large and rapid interest rate hikes, this could increase loan defaults by consumers and impair bank balance sheets.

Another important factor is that South African banks have been much more disciplined in their lending in recent years compared with the 2006‑2008 lending spree – and provisions have been far more conservatively struck for potential bad debts down the line. Capital levels are strong, and banks have generally been well managed in the period leading up to a potential sovereign credit rating downgrade.

According to Butters, “On a risk-reward basis, Prudential is overweight bank shares in our equity portfolios, preferring Barclays Africa and FirstRand, followed by Standard Bank. We also have exposure to Nedbank through Old Mutual. It is too easy to come to the conclusion that investors should avoid banking shares based on the potential of a sovereign downgrade. Second-order thinking is required during these challenging times. While bank share prices would almost certainly be hit in the short term in the event of a downgrade to junk status, SA banks offer good long-term value and attractive dividend yields at current levels.”