Rat­ing cuts – the sword of Damo­cles over our heads

The Star Early Edition - - OPINION & ANALYSIS - Ryk De Klerk

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!

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