​Press Room

Junkmageddon


Matthew Chapman
Mar 31, 2016
Is a potential downgrade to sub investment grade the end of the world?

Junk status– will it or won’t it happen in South Africa? Recently, much has been written on, spoken about and, in some of the more animated members of parliament, communicated vigorously about the risk South Africa faces of a downgrade on its foreign currency denominated long term debt to a sub-investment grade rating. What this will mean for capital markets; the budget deficit and the rand (often used as an emerging market currency proxy/punching bag), has already been covered in various publications, including a piece by NFB last week in “Effect of a Downgrade”. This article will dig a more deeply into the technical aspects and probability of a downgrade, as well as examining the short- to medium-term impact recent downgrades have had on some of the other BRICS countries.

You may notice in the previous paragraph, the specific and somewhat elongated reference to the debt under threat – this is no mistake. Ratings agencies have four separate categories of sovereign debt when conducting a ratings review: short-term locally denominated debt; long-term locally denominated debt; short-term foreign denominated debt and long-term foreign denominated debt, the last of which is in the firing line of the ratings agencies. This category refers to bonds that have a term of longer than a year and are denominated in foreign currency, usually the US dollar. Out of the aforementioned four categories, this is the most risky due to currency risk and duration risk. This is the debt at risk of a downgrade.

The situation as it stands across the Big Three rating agencies (S&P; Moody’s and Fitch) is as follows:

Agency

Rating

Levels Above Junk

Outlook

S&P

BBB-

1

Negative

Moody’s

Baa2

2

Negative

Fitch

BBB-

1

Stable

 

In June of this year, S&P and Fitch who each assign a rating of one notch above junk, S&P with a negative outlook though, will review South Africa’s credit rating. It is here where the market is expecting a watershed moment if South Africa is downgraded by at least one of the agencies to junk. In this regard it must be noted that South Africa’s foreign denominated debt in relation to total government debt stands at just 9% of the roughly R2trn currently in issue. Another widely cited negative outcome of a sub-investment grade rating is the potential forced selling of junk bonds by global pension funds and other sovereign wealth funds, who may be restricted from holding high yield debt. Whilst this is a legitimate concern, the threat of further yield spread and currency deprecation may already be priced into the market as illustrated below.

The scatterplot charts the relationship between and statistical relevance of the credit default swap (CDS) spread against a simple average of the top 3 credit ratings agencies scores. The CDS spread is essentially the annual premium to insure against a default. The horizontal purple line indicates a majority rule junk rating from the Big Three ratings agencies.

 

Credit Swap  

(Source Thomson Reuters, NFB Asset Management)

 

Two key points can be derived from this analysis:

  1. The statistical relevance of the model with an R2 of close to 0.8, which shows an 80% model fit –indicating that the relationship between CDS spreads and credit ratings is statistically significant.
  2. Being below the regression line indicates that the market prices your debt as more risky than the credit ratings agencies, or possibly even indicating a pre-emptive price/market move for a short to medium term future downgrade.

South Africa’s position on the scatterplot indicates that while the agencies have maintained an investment grade rating, the market has already priced South Africa at junk status with a CDS spread of 3.5%. Russia, which has already been downgraded by both S&P and Moody’s, has a spread of 3.2%, indicating that investors view South African sovereign debt as more risky than that of Russia. Other comparable countries highlighted include Turkey at 2.9% and Brazil at 4.4%.

Each of these countries have their own domestic problems to deal with. Turkey is battling with political uncertainty and geopolitical safety worries; Russia is feeling the effects of global sanctions from the Ukrainian issue coupled with a deep rout in the oil price and Brazil is battling with widespread corruption investigations related to Petrobras,. All three share in South Africa’s pain of the fall in global commodity demand associated with the slowdown in Chinese growth figures. In our own backyard we have the additional embarrassing matter of the finance minister merry-go-round.

In terms of Brazil and Russia there appears to be no defined correlation between a ratings agency downgrade and rapid deprecation of the currency. This may be an effect of pre-emptive pricing by the market and it is reasonable to conclude that there is no guarantee that the rand will depreciate towards R20 to the dollar as some market commentators have suggested.

Currency 

(Source Thomson Reuters, NFB Asset Management)

 

A very similar pattern exists in terms of CDS spreads failing to react to credit ratings agency downgrades. At both Russian downgrades the spreads actually tightened and in the case of Brazil there was one widening, one tightening and one largely stable reaction.

Cost of capital 

(Source Thomson Reuters, NFB Asset Management)

 

Whilst there is a material threat of a downgrade to junk in December this year, if not June, there is an unconvincing statistical argument behind the pessimistic view of a rand which falls faster than van Rooyen and a ballooning cost of capital.

Factors affecting the rand and the South African cost of capital are the result of a far more complex web of fundamental macroeconomic indicators, coupled with sentiment driven volatility on the back of policy shocks and state rhetoric. Attention needs to be focused away from the Wall Street offices of the ratings agencies and concentrated on how every South African can contribute to repairing the structural and political issues they face, which put us in this position in the first place. We all have a voice and the capacity to do our part in reinvigorating growth and earningthe investment grade rating that should be enjoyed by an emerging market open to investment by foreigners.

“It doesn’t matter if it’s too little too late – let’s give it our best shot. We don’t have time to worry about that. Afterwards, if it’s too late, at least the people will say we tried. We weren’t always investment grade, we had to earn it. The challenge is, can we talk with one voice, can we project one picture?” – Pravin Gordhan.