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Sovereign ratings:The devil is in the detail

Apr 04 2017 18:57
*Mark Ingham

The detail in the S&P ratings review statement is rather more worrisome and, if ignored by government, would have serious ramifications for funding ability, writes independent investment analyst Mark Ingham.

S&P GLOBAL Ratings did not wait until the scheduled ratings review in early June to initiate a negative rating action nor did it mince words, with toxic politics and maladministration an overriding catalyst.

While this was entirely avoidable, the reality is that the rating action reflects the cumulative effects of rottenness over years. As history teaches us, going bust happens gradually at first, then suddenly.

While attention has focused on the headline grabbing “junk” status, as if the entire apple cart were now junk, there are some interesting detail aspects, found in the full review, that warrant emphasising. The detail is rather more worrisome and, if ignored by government, would have serious ramifications for funding ability.

For investors, things aren’t all bad, and there are good companies on the JSE that you’d want to remain exposed to, but one needs additional caution as to what one is exposed to and at what price levels in the equity market. Developments in the bond market need to be especially taken note of as these price signals will travel to other asset classes and to the real economy.  

As recently as the last review, dated 2 December 2016, S&P kept to a polite carrot and stick in its narrative but the subtlety in that review carried a clear message that there was no scope for slippage.

There were some suggestions as to what could be done to have an upward revision but it stated clearly that S&P “could also lower the ratings if we believed that institutions had become weaker due to political interference affecting the government's policy framework”.

The recently aborted visit by the erstwhile finance minister to London, Boston and New York was crucial to keeping funders on side and confident in South Africa’s policy framework. Even as he landed in London, only to be unceremoniously called back within hours, the ex-minister had no idea that his carefully prepped message to foreign funders was a lie.

The best united efforts of Treasury, business, trade unions, and faith groups over months too was being sabotaged.    

Short-term currency downgrade

There are two aspects to the latest ratings decision, foreign and local. Both have an investment and sub-investment grade implication. In S&P language, down to BBB is investment grade, but with shades of grey, whilst BB down to D is speculative grade.

In December, the long- and short-term foreign currency ratings was affirmed at BBB-/A-3. However, what we have now is disturbing because while the long-term foreign currency sovereign credit rating has moved to BB+, or the first rung of speculative grade, the short-term foreign currency rating has been lowered to B from A-3.

S&P considers A to mean an “obligor's capacity to meet its financial commitment on the obligation is still strong”.

However, B is a different story. In S&P’s words, “apart from the notion of general economic stress, issuers and obligations, particularly those at the lower rating levels (BB and B), may be vulnerable to default even during benign conditions because of sector-specific or issuer-specific characteristics and events”.

This short-term foreign currency downgrade has seemingly got lost in most analysis. 

What also need to be considered is the local rand debt rating, which is also ominous if economic recklessness continues unabated.

In December, S&P lowered the long-term local currency rating BBB from BBB+ and affirmed the A-2 short-term local currency ratings. The long-term local currency rating has been reduced again, to BBB- from BBB. The short-term local currency rating moves down a peg to A-3 from A-2.

This means that the important rand debt rating is at the bottom rung of investment grade according to S&P and skirting with speculative grade, a fate no country wants.

Cost of servicing debt

The long-term national scale rating goes down to zaAA- from zaAAA. S&P’s national scale credit ratings are an opinion of an obligor's creditworthiness. National scale credit ratings provide a rank ordering of credit risk within the country. Given the focus on credit quality within one country, national scale credit ratings are not comparable between countries.

The latest budget from Treasury estimates that government need to borrow R2.5 trillion in 2017/18. This is 23% more than in 2015/16. However, R263bn is assumed to come from foreign currency loans in overseas markets. This means foreign borrowing at 11% of gross debt, slightly higher than the 10% of recent years. The annual gross borrowing requirement is around R250bn.

The cost of servicing foreign debt is R14.3bn and the cost of domestic debt is R148.1bn for a total of R162.4bn or over 13% of revenue. S&P point to the risk of higher real interest rates.

So, the long-term foreign currency rating relates to the R263bn – roughly 10% of government total debt. This is now sub-investment grade. The R2.2 trillion relates to domestic rand debt, which is just on investment grade.

However, non-resident foreigners hold 35% or about R800bn of the government's rand-denominated debt, which makes financing costs vulnerable to overseas sentiment, rand volatility, and an increase in developed market interest rates, not least the Federal Reserve. Local pension funds hold 30% of domestic government bonds.

The terming of bonds, rollovers and scheduling is important here. An investment strike or investor jitters could negatively affect government funding requirements, liquidity, and pricing.

What is more concerning is the possibility of both foreign currency and rand debt being marked to speculative grade. Brazil, for example, has both foreign and local currency at sub-investment grade and is a useful comparison of how the punitive financial implications of poor governance can hasten change for the better.

A move to BB+ on local rand debt directly affects the 35% of local debt funded by foreign investors buying debt in the local bond market. Many have mandates that eschew sub-investment grade. Whilst all the R800 billion isn’t necessarily at risk, particularly if higher interest rates compensate for the risk, it does represent a potential multi-billion fund shortfall.  

The ten-year R186 bond yield has moved up 40 to 50 basis points since the finance minister was fired to around 9% and remains vulnerable to unfolding developments.   

READ: Banks lose R61bn on Gordhan ouster, S&P downgrade

Moody’s is doing a thorough review, which doesn’t bode well.

In the meantime, traders should take ultra-short term positions on interest-sensitive stocks, with banks the most volatile to changing sentiment in this regard and vulnerable to bond market developments. However, the capital adequacy of the big four insulates them from large shocks. Insurers are less volatile and from a balance sheet point of view well placed too.

I retain my cautious view on retail, with the odd exception, but this is independent of the debt downgrade and more to do with the business cycle and relative rating.

*Mark Ingham is an independent investment analyst who wrote this piece for EasyEquities.

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