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Does a credit downgrade to ‘junk’ matter?

South Africa narrowly escaped a foreign currency sovereign downgrade to “junk” from S&P on Friday. This is in addition to Moody’s maintaining its rating at BBB- a week earlier. In both instances, the two rating agencies have a negative outlook on the country, indicating that SA may not be out of the woods yet.

in the money with NESBERT RUWO & JOTHAM MAKARUDZE

BRICS New Development Bank president Kundapur Vaman Kamath
BRICS New Development Bank president Kundapur Vaman Kamath

Moody’s revised its outlook for SA from stable to negative, citing elevated political risks, lower business confidence, lower GDP growth, and increasing budget deficit.

A number of countries have recently had their credit ratings downgraded to sub-investment (junk) status. While there have been numerous waves of downgrades over the decades, the most recent wave of downgrades is the post-commodity super-cycle which hit commodity-exporters during 2015-16 of which Brazil, Azerbaijan and Russia have been victims. A downgrade to junk could take years to undo. Of the 20 countries downgraded to junk by S&P in the past 30 years, only six have managed to regain the investment grade status. 

Who are these rating agencies and why do they matter?  There are at least 70 rating agencies globally, but the industry is dominated by the big three — S&P, Moody’s and Fitch. These three control at least 90% of the rating business, and most investors base their decisions on ratings from these three. While there are slight differences in the rating scales that the big three use, all fall into two broad categories —investment and speculative (high risk) grades. An interesting development in the industry has been the recent statement from the Brics New Development Bank president Kundapur Vaman Kamath that the bank should establish its own credit rating agency, citing concerns that methodologies used by the big three rating agencies were constraining growth in emerging markets.

Despite these concerns from the New Development Bank and also from other quarters, the rating outcomes from the big three still underpin most investors’ decision-making processes. The ratings have an important signalling effect to investors.

When assessing a country’s credit rating, the rating agencies consider the country’s economic structure and performance (e.g GDP growth, investment, inflation), financial status (government local and external borrowings, budget deficits) and aspects such as political risk and other external and internal susceptibilities. When reviewing sovereign ratings, rating agencies engage with various stakeholders in government, labour, civil society and the private sector. The private sector provides a view independent of the government’s, thereby allowing the rating agency to have a balanced view.

A credit rating reflects a borrower’s credit worthiness, that is, it provides a measure of the likelihood of a borrower defaulting on a loan or paying back a loan in line with the agreed loan terms. It follows that the higher the credit rating, the higher the credit worthiness of a borrower, and vice versa.

The credit ratings are used by various stakeholders and for different reasons, and the most important is that they provide a guideline to investors as they (investors) make investment decisions — to invest, hold or exit from a country or investment. The rating provides, to a larger extent, an independent and objective assessment of the credit worthiness of an investment (country or company). All things being equal, a country with a sovereign rating gets more attention from international investors than one without a rating. It’s unfortunate that Zimbabwe is currently a non-rated country and this could in some way be stifling the country’s ability to get the attention of international investors.

Ratings are a key element in determining the cost of borrowing. A higher credit rating, ceteris paribus, assists a rated institution or government to raise funds at a lower cost.  A 2016 World Bank discussion paper on the impact of a downgrade to a junk status (sub-investment grade) shows that in a study of 20 countries between 1998 to 2015, a downgrade to sub-investment grade by one major rating agency pushed up treasury bill yields, on average, by 138 basis points, followed by another 56 basis points, should a second rater follow suit. The yields on the SA government’s external debt as well as the cost of credit insurance is already within the ranges of the sub-investment grade sovereigns as the financial markets are already pricing in junk status on SA.

Given the above, the ratings could also act as some kind of moral suasion that forces countries to pursue more prudent monetary and fiscal policies. Countries with robust fiscal and monetary policies and performance are rewarded with higher credit ratings, which implies lower cost of borrowing, and better chances of attracting investments. One could also use credit ratings as a measure for assessing their relative performance when compared to peers. For example, SA should be comparing itself with other member of the Brics grouping.

For the man on the street, a downgrade to sub-investment grade could mean a tougher life. Simplistically, a downgrade to junk means investors generally, will avoid investing in a country, forcing asset prices to drop, weakening of currency, and rising of inflation. Cost of borrowing (interest rates) will rise, which makes funding and debt service expensive. This could go on for a while as it takes a long time to restore investment grade status.

In a global investment market, credit ratings are a critical element that stakeholders can ignore at their peril if they intend to play in that market. Investors globally are assessing the trends in the country ratings and using these for investment planning.  With at least 20 countries (including the UK) that have had their ratings downgraded this year, a record by most measures, and with most countries under “negative” outlook, investors would have to deal with the prospects of a shaky global economy.

Nesbert Ruwo (CFA) and Jotham Makarudze (CFA) are investment professionals based in South Africa. They can be contacted on media@opportunvest.co.za

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