The ins and outs of ratings downgrades

19 July 2016

South Africa’s sovereign credit rating has been steadily downgraded over the last four years and the pace of the negative ratings trajectory looks set to continue despite the recent reprieve received from Standard & Poor’s on 3 June affirming South Africa’s investment grade rating albeit with a negative outlook.

The rating debate has intensified since December 2015 when not one, but  two, South African ministers of finance were replaced in quick succession. This promptly sent the bond market and the rand into a tailspin. Since then, the extent of damage control has been prolific with Finance Minister Pravin Gordhan stating that the government must “do whatever is necessary to avoid a cut to sub-investment grade”. As a result, we have witnessed an increased dialogue between government and business, providing some form of encouragement. However, this has not yet produced any hard evidence that the structural reforms needed to promote growth in the economy, have, or will be addressed in the near future. This inaction, coupled with, a lack of bold remedies in February’s Budget presentation leaves the country with the seemingly inevitable hanging over its head: a downgrade to BB+ by at least one rating agency.

But, despite the national discourse being fueled by ratings downgrade talk, many investors are unsure of the full implications of such a move or, indeed, the role of ratings agencies.  

Sovereign ratings: The basics 

A sovereign credit rating is an opinion about the creditworthiness of a country. This is determined through an assessment of the sovereign’s ability and willingness to honour its existing and future obligations  in full and on time. There are a wide variety of credit ratings that are produced by a number of international and local credit rating agencies, including both foreign currency and local currency ratings as well as the agency’s future outlook for such rating.

There are currently three global rating agencies that rate South Africa: Moody’s Investor Services (Moody’s), Standard & Poor’s (S&P) and Fitch Ratings. The sovereign rating methodologies of the three agencies are broadly similar and measure five assessment factors to determine the final rating:

With regard to the fiscal assessment, South Africa’s metrics are more closely aligned with the BB rating band averages as indicated below:

In recent years the biggest threat to South Africa’s sovereign rating has been disappointing economic growth. The latest official forecast from the 2016/2017 Budget was revised to 0.9% for this year and 1.7% for 2017, down from 1.7% and 2.6% respectively. S&P has also now revised its forecast to 0.6% down from 1.6% as of December. The inability to achieve this moderate 1.6% growth comes down to weak external demand, continued low commodity prices, domestic constraints and weak business confidence inhibiting substantial private sector investment. All factors which seemingly seal the deal for a downgrade in December 2016 by S&P. Similarly, Moody’s and Fitch have forecasted 2016 GDP growth at 1.4% and 1.7%, respectively.

Why do ratings matter?

Sovereign credit ratings are an indicator of the risk level associated with the investment environment of a country and are used to determine the risk premium payable on debt instruments issued by the country. This will often also have spillover effects to the corporate, bank and state-owned company (SOC) debt markets, as these entities mostly raise debt at a premium to government, which is viewed as the least risky borrower in a country. Both bank and SOC ratings will generally be downgraded following a sovereign downgrade. This is due to the deterioration in government’s ability to support its banks and SOCs as a result of weaker government fundamentals and weaker ratings uplift assumptions. These adjustments may trigger some form of general re-pricing of the cost of credit in South Africa.

Sovereign credit ratings may also be a factor in determining the inclusion of a country’s bonds in a government bond index. Index inclusion is important as this creates a natural demand for a country’s bonds within passive investment strategies. Notable inclusions for South Africa are the Citibank World Government Bond Index (WGBI) as well as the JP Morgan Emerging Market Bond Index (EMBI). While the WGBI does have a minimum local currency investment grade rating requirement from Moody’s or S&P, the JP Morgan EMBI has no rating requirement for inclusion and “may invest without limit in securities that are rated below investment grade”. While the South African foreign currency rating will most likely be downgraded to sub-investment grade by S&P, and possibly Fitch as well this year, the local currency ratings are still three, and two notches away from sub-investment grade. This implies that a mass exodus of passive holdings of South African government bonds as a result of ratings downgrades is an unlikely occurrence in the medium-term. However, many institutional investors operating  under discretionary mandates are limited  to investing into investment grade bonds. This may cause some forced selling but we expect this to be orderly as the potential downgrade has been well telegraphed to the markets. In the long term the inability of these funds to buy sub-investment grade debt may limit the availability of capital to finance South Africa’s borrowing needs, leading to increased costs as new pools of capital would have to be incentivised to make an investment decision.

Sovereign credit ratings may also be a factor in determining the inclusion of a country’s bonds in a government bond index. Index inclusion is important as this creates a natural demand for a country’s bonds within passive investment strategies.

What is the market telling us?

Since the global financial crisis, rating agencies have been widely criticised for being backward looking and for failing to take timeous action. The nature of the ratings process, however, involves analysing historical quantitative information and it is therefore helpful to compare traditional credit ratings with market indicators such as credit default swap (CDS) spreads, bond yields and the market implied ratings (MIR) displayed by such traded instruments. CDS spreads are  often used as a proxy for the credit risk premium, which is quantified as the cost of insuring debt against a default.

We look at these indicators to determine what the market is telling us a sovereign rating should be. The Moody’s bond and CDS MIR currently indicate a two and five notch gap between the published rating and the market priced ratings. This implies that bond yields and CDS spreads are currently pricing South African ratings as low as Ba1 and B1 - in line with Morocco, Portugal, Hungary (Ba1) and Kenya, Uganda and Vietnam (B1).

What happens next?

Not only do South Africa’s fundamental rating indicators appear in line with sub- investment grade averages, but market indicators such as CDS spreads and  MIR ratings echo the fact that South Africa is de facto a sub-investment grade country. The question now is: What would the impact be of a foreign currency downgrade to sub-investment grade on the local bond and credit markets?

Simply put, probably not much. Ashburton Investments believes the local government bond market has largely priced in a downgrade and that the specific impact  on bond yields at the time of a downgrade will be driven mostly by the outlook for a recovery in the global economy, especially the United States. From a local equity market perspective, valuations will be influenced by prevailing risk free rates (i.e. 10 year bond yields) and much will depend on the reaction here. 

At a country level, however, research by Avior indicates that, on average, bond yields, currency and CDS spreads peak on the date on which a country is downgraded, and could improve from then. However, other possible consequences of a ratings downgrade could include further negative sentiment on foreign investment, a rise in the cost  of capital, continued high levels of rand volatility, decreasing competitiveness of South African businesses in Africa and elsewhere and further diversification (externalisation) efforts by SA Inc. Clearly, already challenging market conditions will become even more difficult. 

What is also of concern is that, on average, it takes a country seven-and-a-half years  to regain its investment grade rating, if at all, once it has been downgraded to sub- investment grade. Changing the negative ratings trajectory would require more than is currently being done from a policy and economic perspective to stimulate GDP growth and provide much-needed business confidence to the private sector. 

Our portfolios are positioned to look through this short-term volatility and take advantage of compelling medium-term valuations in equities, bonds and property. During this time of uncertainty, our approach is to stick to the basics: select counterparties carefully, ensure we are  well positioned to execute as opportunities arise, and ensure that each of our assets is priced for value through the cycle.

Download a PDF of the Global Perspectives magazine
Read other articles in the Global Perspectives magazine onscreen