Government bonds and credit ratings: How they work and why they matter | Fin24
 
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Government bonds and credit ratings: How they work and why they matter

Mar 15 2016 12:00
Simon Brown

With a possible downgrade of SA’s investment grade to junk status, I thought it worthwhile to help you gain an understanding of what the downgrade is all about and how bonds work.

The three ratings agencies – Standard & Poor’s, Fitch and Moody’s – all put out ratings on debt issued not only by countries, but also by corporates and state-owned enterprises.

These ratings are far from perfect, as illustrated by the collapse in 2008/09, which was in part due to highly graded debt instruments actually being of a very low quality. Nonetheless investors take heed of the ratings.

As things stand right now, Standard & Poor’s is the one to watch, as it has rated SA one notch above junk status with a negative outlook.

Fitch's rating is at the same level, but with a stable outlook, while Moody’s is a notch above these two, with a negative outlook. Standard & Poor’s will update its rating mid-year and again in December.

If we slip into junk status it will increase the cost of our debt as our government bond yields will increase.

The ins and outs of bonds

So how do bonds work? Bonds are debt instruments and they’re the same, regardless of who issues them; in simple terms, it’s money being lent to the bond issuer.

At first the issuer will sell or auction off a series of bonds – for example 25 bond units at R1m each, making for a total of R25m.

They will have a fixed rate of interest (called the coupon) that is either set via an auction process or by the issuer. This coupon is guaranteed and the principal loan will be paid back at the end of the bond’s term.

So staying with the example above, if the coupon is 9% a year and the duration is 10 years, an investor in the bond pays R1m up front, receives R90 000 every year and at the end of the 10 years gets their R1m back.

The trick is how they trade and here a simple saying can be used to explain it: “Yield up, price down.” Yield, via the coupon rate, is set when the bonds are issued, but it will change.

The price/yield relationship

Here’s what you know as a buyer of the bond: when it matures, what the annual payouts are and how much you’ll be paid out in the end.

Of course default risk is important – this is where ratings agencies come in – they essentially grade the ability of the issuer to repay the monies.

So if you hold one of the R1m units with a rate of 9%, you would be selling the income – or R90 000 a year – and the repayment of principal.

However, the metric used to price bonds is the rate rather than the principal loan amount. Very importantly, the actual rand value paid out every year and the final bond value are fixed.

So rather look at what you get with every payout (in this case R90 000 a year).

An investor who feels the risks are increasing may want a higher return than just R90 000 (9%). If they want a R100 000 or 10% payment every year, the value of the bond must decrease.

So instead of trading at R1m, the bond would trade at R900 000. With an interest payment of R90 000, that would equate to a 10% yield.

What a bond buyer is doing is buying cash flow that is fixed but the amount paid is what changes. Hence, “Yield up, price down.” So with our local bond yields increasing, it means prices are falling.

Impact on SA

What does all this mean for SA? Well, government bond yields are moving higher as bond investors start to price in the downgrade (this started back in December). Our yield on the popular R186 government bond has moved from around 8.2% to 9.2% over the last three months.

So government debt will cost more. The cost of existing debt remains unchanged – that rate is locked in. But the existing bonds will expire (typical bond duration is two to 10 years) and will need to be replaced at these higher bond yields. Further, the Budget Speech of 24 February saw a shortfall of income to revenue of some R139bn –  money we have to borrow at the new higher rates.

The net impact is a higher cost of debt for the government. This has to be funded by higher taxes and our only real route out of this spiral is real economic growth (GDP growth) of at least 3%.

This article originally appeared in the 10 March 2016 edition of finweek. Buy and download the magazine here

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