Living in a BB plus world Version 2.0 (We have been here before...)

Following the announcement by Moody’s on 27 March 2020 that it has downgraded the Government of South Africa’s credit rating from Baa3 (BBB- equivalent to other rating agencies) to Ba1 (BB+ equivalent to other credit rating agencies) with a negative outlook, it is important to provide investors with insight as to how this will impact South African credit markets and how South African investors should approach the credit ratings of their fixed income investments.

It is worthwhile remembering that we have been here before, after Standard & Poor’s (S&P) and Fitch downgraded the Government of South Africa’s credit rating to below investment grade during April 2017. Following these downgrades there was much confusion, but the impact on the credit market was relatively benign. At the time, the South African credit markets were experiencing a spread tightening cycle which commenced in mid-2016. Other than limiting issuance in the period immediately following the downgrades, these actions did not have a material impact on credit spreads, with the spread tightening cycle continuing unabated through to the first quarter of 2020.

This downgrade by Moody’s may however have a larger impact on South African credit markets as the agency has a broader list of issuers in its network of ratings than S&P and Fitch. This will result in the credit ratings of more South African issuers being impacted by downgrades in response to the sovereign rating downgrade. Important to note, only issuers that are assigned ratings by Moody’s will be impacted by the sovereign downgrade until such time other credit rating agencies pronounce on their views of the South African sovereign rating.

However, to provide more insight on the potential impact that the downgrade will have on the assessment of credit risk,
we’ll start from first principles.

What is a credit rating?

A credit rating is an assessment of the creditworthiness of a borrower and the likelihood that it will meet its financial obligations in full and in a timely manner. A rating can be assigned to any entity that seeks to borrow money including corporates, sovereigns and structured finance vehicles. Credit assessments are mainly done by global credit rating agencies such as S&P, Moody’s or Fitch. However, regional rating agencies also exist, such as Global Credit Ratings (GCR) in South Africa.

What types of ratings are assigned to borrowers?

Rating agencies typically assign two types of ratings; the “international/global” and “national/local” scale ratings.

International scale ratings assess the creditworthiness of a borrower relative to all other borrowers across the globe. Such a rating provides a consistent benchmark for investors with a global focus who require consistent comparisons across multiple countries and, possibly, different types of borrowers.

National scale ratings assess the relative creditworthiness of borrowers within a specific country and are primarily used by domestic investors.

When determining national scale ratings, country-specific risks faced by all local entities are not seen as differentiating factors, while such factors may well impact on the international-scale rating assigned to a borrower.

Rating agencies assign both “foreign currency” and “local currency” international scale ratings to a borrower.

Foreign currency international scale ratings refer to the ability of a borrower to settle its foreign currency denominated debt obligations in full when they are due. This rating is of increased significance when assessing the credit-worthiness of borrowers who may be relying on earnings, denominated in a currency other than that of the debt obligation, to repay their foreign currency debt. Local currency international scale ratings refer to the ability of a borrower to meet its debt obligations that are denominated in the currency of the country in which the borrower is situated. An important technical point to note is that this rating does not take into account the impact of foreign exchange controls or the ability for the borrower to access hard currency in order to make timely payment on their debt.

In the event where the international scale rating of a borrower assigned by S&P or Fitch is BBB- (Baa3 in the case of Moody’s) or higher, such a borrower is referred to as “investment grade”.

Why do we need national scale ratings and why has the South African fixed income market operated on this basis?

In South Africa, domestic fixed income investors mainly rely on national scale ratings when assessing the credit risk and level of risk-adjusted returns of different borrowers. National scale ratings provide increased differentiation across borrowers in a country. The international scale sovereign rating is an important input into the rating process and the level of such rating often limits the potential ratings of borrowers situated in that country. This is referred to as a “sovereign ceiling”. In the case of lower international scale rated countries such as South Africa, this results in a cluster of high quality,
non-sovereign borrowers from that country that are assigned international scale ratings similar to the level of the sovereign.

This may make it difficult to sufficiently differentiate credit risk across these borrowers by considering only the international scale rating. Typically, for a given country, the sovereign is seen as the strongest credit issuer, affording it a national scale rating of AAA. This is mainly driven by the ability of governments to print local currency and raise taxes, thereby increasing the sovereign’s ability to meet its debt obligations in full. Non-sovereign borrowers within a country would then be assigned a national scale rating based on their international scale rating adjusted for their strength relative to the government of the country in which they are domiciled.

For these reasons, South Africa has been, and in our view will continue to be, a market where national scale ratings are the
“lingua franca” of most fixed income investors.

The manner in which national scale ratings are mapped to international scale ratings by the various different rating agencies, following the Moody’s downgrade, is displayed in Table 1 below.

Table 1: International scale ratings and associated national scale ratings as at 27 March 2020

Table 1 BB plus world

Source: Ashburton Investments

How have South Africa’s credit ratings changed?

South Africa’s initial rating migration into sub-investment grade territory was led by S&P and Fitch following a cabinet reshuffle conducted on 31 March 2017. Moody’s was the last international credit rating agency to downgrade the sovereign rating to
sub-investment grade. A timeline of the major moves in the sovereign rating since the initial downgrades to sub-investment grade are set out below:

  • S&P – 3 April 2017: foreign currency, international scale rating: BB+ (downgraded from BBB-) and local currency, international scale rating: BBB- (downgraded from BBB).
  • Fitch – 7 April 2017: foreign currency, international scale rating: BB+ (downgraded from BBB-) and local currency, international scale rating: BB+ (downgraded from BBB-).
  • Moody’s – 9 June 2017: international scale rating: Baa3 (downgraded from Baa2).
  • S&P – 24 November 2017: foreign currency, international scale rating: BB (downgraded from BB+) and local currency, international scale rating: BB+ (downgraded from BBB-).
  • Moody’s – 27 March 2020: foreign and local currency international scale ratings: Ba1 (downgraded from Baa3).

In summary, all of the major global ratings agencies have determined that the credit risk of South Africa has increased.

The current ratings assigned by the major global rating agencies are set out below:

Table 2: Ratings assigned as at 27 March 2020

Table 2_ ratings assigned
Source: Ashburton Investments

What about the South African banks, SOCs and corporates?

Traditionally, the major South African banks (Absa, FirstRand, Investec, Nedbank and Standard Bank) have been the largest issuers of credit in the South African debt capital market, with their instruments also generally being the most liquid in the credit market.

Therefore, the impact of the South African sovereign rating downgrade on the ratings of the banks is a material event for the South African credit market. The ratings of South Africa-based banks, state-owned companies (“SOCs”) and sovereigns are constrained by the country’s sovereign rating given the direct and indirect impact of sovereign distress on domestic operations.

This is evidenced by the actions of S&P and Fitch in 2017, where these agencies also downgraded the ratings of the South African banks, SOCs and corporates rated at the sovereign rating level following their sovereign rating downgrades. Further, after Moody’s changed its rating outlook on South Africa to negative on 1 November 2019, it resulted in the rating outlooks on almost all the counters which are rated in line with the South African Government also being placed on negative outlook.

We therefore expect a number of credit ratings issued by Moody’s for SOCs and corporates to be downgraded in line with the credit rating of the sovereign.

Importantly, where Moody’s assigned international scale ratings which were previously below the sovereign rating of South Africa, these international scale ratings may remain unchanged. However, there is no guarantee of these issuers retaining their ratings.

How do rating changes impact the South African credit markets?

To understand the potential impact of the Moody’s sovereign downgrade, we have to look at the most recent example (i.e. April 2017). Following strong issuance in excess of c.R18bn during March 2017, practically all debt auctions scheduled in April 2017 were cancelled after the sovereign rating downgrades by S&P and Fitch.

This reaction was similar to what was observed during other events such as African Bank being placed under curatorship in August 2014 and the replacement of Nhlanhla Nene as finance minister in December 2015. Following these events, the market activity took between two and four months to return to prior levels of issuance.

The current downgrade by Moody’s comes at a time when conditions are different compared to 2017. During 2017,
interest-bearing funds were experiencing significant inflows and credit spreads were tightening due to the supply/demand dynamics in the market. In the current environment faced by South Africa with regards to the COVID-19 related lockdown, we have already seen a number of cancelled auctions by South African issuers, including Transnet SOC Ltd, Resilient REIT Ltd and the Development Bank of Southern Africa. Further, we have seen upward pressure on trades in the credit market, particularly in the subordinated instruments issued by banks, whilst corporates have also been issuing instruments via private placement at higher spreads than what was achieved previously.

Given the high levels of uncertainty in South Africa, there may be some upward pressure on credit spreads. This could however be offset to some extent by a decline in supply of listed credit assets for a longer period of time, as issuers and investors look for the environment to stabilise.

One area where confusion will be less than during the April 2017 downgrades relate to the updating of Moody’s national scale mapping table. Moody’s has standardised its mapping tables across different sovereign ratings, therefore the new mapping table for South Africa at a Ba1 sovereign rating will already be in effect. During the prior rating downgrades in April 2017, there were a number of anomalies in national scale ratings as S&P and Fitch delayed the publication of their national scale mapping tables. Further, the major rating agencies all have similar sovereign ratings which will result in the national scale rating mapping tables being more aligned across the different rating agencies.

An indication of international scale ratings by more frequent issuers which (rated at the same level as the sovereign prior to the downgrade) may be impacted by the recent Moody’s downgrade, based on Moody’s adjustment of rating outlooks in November 2019 is listed below:

Table 3: Issuers which may be impacted by recent Moody’s sovereign rating downgrade

Table 3 Moodys sovereign rating downgrade
Source: RMB Global Markets Research

It is important to note that no downgrades on any of the above issuers have been formally announced by Moody’s and the table should not be seen as confirmation of any rating downgrades currently.

Further, given that Moody’s have updated its national scale mapping table, there is a probability that the national scale ratings of the above issuers may remain unchanged in some instances, given that their risk relative to the sovereign may not have necessarily deteriorated.

Moody’s did however indicate that certain corporates and SOCs with ratings below the sovereign may also be impacted by the sovereign rating downgrade. In the event of these entities being downgraded from Ba1 international scale ratings to Ba2, it will result in downgrades to their national scale ratings as well. Issuers which may face such downgrades include MTN, Land Bank, Sasol, Hyprop and City of Tshwane, however it remains to be seen if this materialises over coming weeks.

What are the long-term consequences of the national scale mapping table recalibration?

From global precedent, the recalibration of national scale mapping tables following the downgrade of a sovereign rating has resulted in borrowers with lower international scale ratings then mapping to investment grade on the national scale. In effect, borrowers with a higher probability of default (PD) will achieve national scale investment grade ratings solely due to the recalibration of the mapping table, rather than due to an improvement in the ultimate credit quality of the borrower.
All things being equal, this will result in borrowers which were deemed too risky for national scale investment grade mandates prior to the sovereign downgrade now qualifying for inclusion in such mandates.

Moody’s applies a standard approach to deriving the national scale mapping table for South Africa. Given that Moody’s downgraded the South African rating by one notch (to Ba1), the national scale mapping table will change as follows:

Table 4: Moody’s international scale ratings and associated national scale mapping tables as at 27 March 2020.

Table 4 Moodys international rating scale
Source: Moody's

According to the new Moody’s national scale mapping table, borrowers with an international scale rating of B1 (B+) or better have an investment grade national scale rating. Prior to the rating downgrade by Moody’s this cut off for a national scale investment grade rating was Ba3 (BB-).

Further, issuers that are downgraded from Baa3 to Ba1 (international scale), may still receive national scale ratings of or, but may also now be assigned a rating as low as

Finally, issuers that could potentially be downgraded from Ba1 to Ba2 (international scale) may be faced with ratings as low as, where they previously would have been assigned a national scale rating of at the least.

What is Ashburton Investments’ approach to establishing credit ratings?

Ashburton Investments currently assigns a local currency international scale rating to every exposure it enters into. This rating is also assessed on an annual basis, or more frequently if developments regarding the country, industry or issuer arise.
The international scale local currency rating is determined by deriving a PD from internally developed quantitative models, which are overlaid with a qualitative analysis. Our rating is then compared with ratings assigned by rating agencies as a reasonability test.

Previously, the international scale local currency rating was then mapped to a national scale rating using the most conservative mapping among the rating agencies, which was Moody’s prior to the downgrade.

Following the changes to the Moody’s mapping table post the sovereign downgrade, there is greater alignment between the mapping tables of the three major global rating agencies. Therefore, we will continue to use Moody’s.

Concluding thoughts on some evolving implications.

Firstly, it’s worth mentioning some of the interesting implications of the downgrades and associated rating changes:

  • A number of highly rated issuers may now be constrained by a sovereign ceiling leading to a downgrade of those names,
    but lower rated names should be largely unaffected as the impact of the sovereign rating downgrades may be insufficient to impact the stand-alone corporate credit quality to such an extent that a downgrade is required.

  • Following the Moody’s downgrade of the sovereign rating, there is a possibility of the ratings of all the issuers rated at the same level as the sovereign being downgraded. Further, issuers already rated Ba1 by Moody’s (international scale) may not be downgraded but will now have the same credit rating as the sovereign. This will result in a further clustering of corporates rated at the same level as the South African sovereign.

This will lead to a situation where the debt of South African corporates rated at Ba1 by Moody’s (international scale) actually differing in credit risk, as there may be issuers which have fundamentals to support a higher rating but which are being capped by the sovereign rating. It will therefore be important to understand the risk one is taking when investing in issuers with a Ba1 international scale rating from Moody’s and to ensure that this is reflected in the national scale rating the extent that it can be.

Finally, we believe that the long-term impact of the South African rating downgrade could result in investors inadvertently being exposed to inappropriate levels of credit risk in traditionally investment grade mandates, as the international scale rating required to achieve a national scale investment grade rating is lowered. Ashburton Investments will look to engage with investors to address such concerns by either:

  • setting more conservative minimum rating bands or exposure per rating bands for mandates when national scale ratings assigned by ratings agencies are applied; or
  • applying local currency international scale ratings when mandate limits are set.

Corneleo Keevy
Head: Credit Risk Management