Rating cuts – the sword of Damocles over our heads

EARLIER this year ratings agencies downgraded South Africa to speculative grade or junk status and the threat of further ratings cuts is hanging over the country like a sword of Damocles, demoralising and confusing business, policymakers and investors.

Some question the motives of the rating agencies. Are they trying to influence monetary and fiscal policy or do they want to influence political outcomes?

The ratings should be seen in perspective though. South Africa’s derating followed in the footsteps of the other two major emerging economies – Brazil and Russia. The two other Brics countries, China and India, managed to escape the deratings.

But what are the markets telling us about South Africa’s credit risk rating? The inferred risk of investing in a country is reflected by the country’s 10-year government bond yield spread to US treasuries, where the latter is deemed very low risk.

When compared to the credit ratings of agencies such as Fitch and S&P it is evident that in the case of South Africa the bond yield spread leads the credit ratings.

The bond market as early as January 2008 had already priced in a lower rating while the rating agencies only lowered the country’s rating at the end of 2012. Have they underestimated the risk?

Nenegate in 2015 came as a shock that led to the virtual simultaneous widening of the yield spread and the lowering of the country’s credit rating.

History, however, shows that the inferred risk of investing in South Africa as measured by the bond yield spread to US treasuries is event-driven.

It is evident that the bond market is currently unfazed by the recent cut in the credit ratings to junk status and that investors in South Africa’s bond market disagree with the credit agencies’ assessment – for now at least – as the downgrade had little or no effect on the bond yield spread.

In the case of Russia and Brazil their bond yield spreads to US treasuries also lead the countries’ credit ratings and were also event-driven.

In 2008 the spike in Russia’s bond yield spread coincided with the sell-off in crude oil amidst the global liquidity crisis. This led to the downgrading by the credit agencies. The same happened at the end of 2014 when oil prices collapsed.

In the first half of 2015 protests in Brazil and a weakening economy led to the bond yield spread to US treasuries widening. In August that year protests increased and it was announced that the country sank into recession. The sell-off in bonds was followed by a number of downgrades by the credit agencies to junk status.

In Russia and Brazil the bond yield spreads to US treasuries had almost always increased ahead of rating downgrades to junk or near-junk levels and decreased significantly afterwards – “sell the rumour, buy the fact”?

South Africa’s internal and external affairs obviously play a major role in domestic and offshore confidence in the country and therefore creditworthiness. The South African Chamber of Commerce and Industry’s Business Confidence Index is an excellent indicator of where the country’s credit rating is heading.

It is evident that although the downgrade in December 2015 was justified and should have been expected, business confidence (although still low) at the time of the recent downgrades was in fact higher than in December 2015.

The timing of the recent downgrade and warnings of further downgrades can only be ascribed to the rating agencies anticipating a worsening South Africa’s economic and/or socio-political environment or another unknown factor.

Although the credit rating cut in December 2012 led to a resultant drop in the external value of the rand the currency tanked more than a year before the next rating cut in the aftermath of Nenegate. While volatile, the rand is currently near the levels preceding Nenegate.

South Africa’s bond yield spread to US treasuries and credit rating should also be seen in context to other countries. The real yield curve (adjusted for inflation) of the Brics countries is approximately 300 basis points higher than their Eurozone counterparts, given their average credit rating and approximately 200 basis points higher than the Southeast Asian countries.

Disagree

Investors in the South African bond market, rightly or wrongly, are telling us that they disagree with the rating agencies. South Africa’s real yield indicates that the bond market considers the credit rating of the country to be at least one notch higher – that is still investment grade and not speculative. Credit agencies underestimated South Africa’s risk from January 2008 to November 2012. Are they overestimating the risk now?

Downside risk in the South African bond market should not be underestimated though. If the bond market decides to agree with the credit agencies South Africa’s real 10-year bond yield spread to US treasuries could increase to nearly 4 percent from the current 2.8 percent. The South African 10-year bond yield could therefore increase by more than 120 basis points.

No country’s bond market and credit ratings are immune to shocks. If the credit agencies decide to cut South Africa’s rating by another notch and the market buys their story – especially in case of a shock (announcement or other) – the yield spread could rise to 4.2 percent, or 140 basis points, or higher from current levels.

Even in the absence of a shock a further derating of South Africa by the credit rating agencies is likely to lead a spike in the yield spread, but it may be short lived.

South Africa’s junk status in the eyes of the rating agencies is unlikely to change over the short-term.

The Russian experience shows that it could be a mistake to expect improved credit ratings when the country’s rating reached junk level status or bordering on junk status despite the bond markets indicating that the risk of investing in the

Furthermore, business confidence in South Africa will need to improve significantly before the rating agencies will react positively.

country has subsided. (The credit rating of Russia has been unchanged over the past two years.) Furthermore, business confidence in South Africa will need to improve significantly before the rating agencies will react positively.

What will happen to emerging market bonds when developed countries’ central banks tighten monetary policies? The US bond market has already factored in further tightening and the real bond yield spread between US and German government bonds have already opened up to more than 100 basis points – US bonds are offering higher real yields than German bonds. When the Eurozone countries start to tighten it is probable that the gap between the US and Germany will narrow.

The real yield curve per corresponding credit rating of the Eurozone will probably shift upwards and while there may be some upward pressure on government bond yields in developing economies the gap between the real yield curve per corresponding credit ratings of the Eurozone and developing economies such as Brics is likely to narrow from the current 300 basis points.

South Africa has missed out on the global economic recovery compared to other developing nations and cannot afford blunders going forward. It is the bond market, stupid!