Ratings downgrades and your portfolio

South Africa is certainly no stranger to ratings downgrades. In our time, we have weathered many ups and downs in the market and have seen finance ministers come and go. Ratings downgrades started back in 2012 and continued in 2014 as economic growth slowed. At the end of 2015, the three rating agencies (S&P, Fitch and Moody’s) warned that ongoing deterioration of the country’s balance sheet and weak growth was putting the country at risk of another downgrade. Given SA’s position – on the cusp of the investment grade/sub-investment grade threshold – it was foreseen at the time that the next downgrade would be into “junk status”. That has now become a reality.

We interviewed Ockert Doyer, Credit Analyst for Fixed Interest at Sanlam Investment Management, and asked him about his views on where to from here in the medium term.

How significant are these ratings downgrades for the investment markets and for the SA economy?

Says Doyer, investors demand higher returns for additional risk taken, and if the downgrades result in an increased perception of the risk involved in investing in the bonds issued by the SA government, it will result in higher cost of borrowing for the SA government.

Further downgrades will also have other consequences as it will result in South Africa being excluded from the World Government Bond Index (WGBI) and other similar indices. Exclusion from this index reduces the pool of foreign investors looking to invest in SA government bonds (index trackers/passive investors). Foreign investors hold about 35% of the government’s rand-denominated bonds, so this would put further pressure on bond yields and our currency. Estimates vary, but exclusion from the WGBI and other indices could result in up to $8 billion worth of forced selling of SA sovereign bonds.

In financial markets and the investment industry generally, credit ratings continue to be used quite widely. Credit ratings were previously even formally referred to in various pieces of regulation that referenced ratings and specific minimum rating requirements or exposure thresholds based on credit ratings. Since the global financial crisis of 2008/2009, regulators globally have tried to reduce the dependency on external credit ratings and have encouraged investors to do their own risk assessments. Nevertheless, over the years investors have become used to the rating scales used by external agencies and these credit ratings continue to be used in investment mandates as they allow for comparison of risk between different investments and provide a means of expressing risk-return objectives relatively clearly.

Looking ahead and considering the potential path of future rating actions, the policy response from government becomes very important. Policies and actions with a focus on fiscal consolidation, GDP growth and strengthening of South Africa’s independent democratic institutions are the things that are important. It might take a while – countries that have been in a similar position historically have taken up to seven years to get back to investment grade – but unless such policies are implemented, we will not see a return to investment grade status.

Nevertheless, looking at the muted reaction in financial markets following the downgrades (such as bond yields and pricing of South Africa’s credit default swaps) and relative to peers already rated sub-investment grade, we believe that a lot of the negative sentiment has already been priced in. Also, compared to some of our emerging market peers such as Brazil, Turkey and Russia, South Africa remains a relatively attractive investment destination.

The most important thing investors can do in these times is to remain calm, stick to their long-term investment plan and not make rash decisions with regard to their investments.

From our perspective, the downgrades themselves have not necessarily changed our investment views and we believe there may still be good investment opportunities out there, as fear and uncertainty result in markets becoming oversold.

The role credit agency ratings play in investment decision-making for balanced and fixed-income portfolios

Relying fully on external ratings as the only opinion of credit risk is not ideal. Credit ratings agencies do sometimes get it wrong – a classic example being the sub-prime crisis (mortgage-backed securities) in the US in 2008/2009. However, since then, credit ratings agency methodologies, assumptions and processes for assessing credit risk have been considerably refined.

While we use external ratings agencies as additional information, says Doyer, the actual investment decisions themselves are largely driven through our own credit assessments.  The most value derived from external ratings lies in understanding the methodology that is followed to derive the rating. In other words, the rationale or the explanation of the thinking behind the actual credit rating can be useful in informing investment decision making.

Globally, the three large ratings agencies (S&P, Fitch and Moody’s) are dominant, while only two of these three are currently active in the SA market. We asked Doyer if he thought the rating agencies had too much power or influence, and whether there should be more competition in this area. We also asked him how serious the conflicts of interest are when ratings agencies are paid by issuers to rate their bonds.

Says Doyer, conflict of interests due to the ‘issuer pay’ model remain a concern. However, this is somewhat balanced by the reputational risk faced by these agencies to retain investor confidence in their ability to form objective and balanced views. Competition in most industries normally leads to better products/services for consumers, but in the credit ratings business, a few (three, maximum four) large but trustworthy players are probably sufficient. Investors ideally want broad coverage by the agencies they subscribe to and too many different methodologies for assessing credit risk will not necessarily add any real value.

“Facing reality as it is and not as you want it be – shopping around until you get an opinion that you want to hear, rather than an opinion that you need to hear, is a very dangerous approach” concludes Doyer.

Listen to the podcast