In May last year, when the downgrade rumours were already swirling, I wrote a post about how a downgrade to junk status could affect us, the men on the street. It needed to be updated a little, so this is the 2017 version. I also want to point out, before we get going, that South Africa’s foreign currency-denominated debt has only been downgraded to junk status by one ratings agency, S&P. In order for the really big impacts to hit, you need it to be downgraded by two of the three main ratings agencies (so we’re waiting on both Moody’s and Fitch to see if they revise their ratings). It’s also worth mentioning that SA’s rand-denominated bonds are still investment grade – no one has downgraded that debt rating yet. Here goes.
Downgrade to Junk Status
A question that I keep getting asked: “But how will a downgrade to junk status actually affect me? Quickly. Like, in two sentences. Thanks.”
Unfortunately, that’s difficult, because the answer is complex. But I’m going to try and work my way there.
But before you can talk about a credit rating downgrade, we need to talk about credit ratings in general. So let me start with some background for that.
What is a Credit Rating?
A Credit Rating is an ‘independent’ assessment of the credit quality of a bond (or any debt instrument really). And that credit rating is requested from, and then issued by, a recognised credit rating agency.
When credit rating agencies first started, they were just investment research companies. They would do research on the various bonds in the market, publish their views in thick manuals, and then sell those manuals to fund managers and investors. For ease of reference, they applied letter grades to the bonds – with the A grades being good, and the subsequent letters, not so much.
Why are credit ratings so important?
Legislation that governed the financial services industry, including banks, pension funds and insurers, began to restrict those agents to investing only in ‘investment grade’ securities – as defined by a credit rating from the credit ratings agencies.
Here’s an extract from this “A Brief History of Credit Rating Agencies” publication:
[The] relationship between the rating agencies and the U.S. bond markets changed in 1936 when the Office of the Comptroller of the Currency prohibited banks from investing in “speculative investment securities,” as determined by “recognized rating manuals” (i.e., Moody’s, Poor’s, Standard, and Fitch). “Speculative” securities were bonds that were below “investment grade,” thereby forcing banks that invested in bonds to hold only those bonds that were rated highly (e.g., BBB or better on the S&P scale) by these four agencies [RA note: Standard, Poors, Moodys, Fitch – as they were at the time]. In effect, regulators had endowed third-party safety judgments with the force of law.
In the following decades, insurance regulators and then pension fund regulators followed with similar regulatory actions that forced their regulated financial institutions to heed the judgments of a handful of credit rating agencies.
In 1975, the Securities and Exchange Commission (SEC) issued new rules that crystallized the centrality of the rating agencies. To make capital requirements sensitive to the riskiness of broker-dealers’ bond portfolios, the SEC decided to use the ratings on those bonds as the indicators of risk.
At this point, people began worrying about the term ‘recognised rating manuals’ – because who’s to say what counts as ‘recognised’? I mean, if I pay you to give me a good credit rating, and then I alone choose to recognise it – is that enough to say that the rating is ‘recognised’?
Who gets to issue a credit rating?
To enable enforcement of those new financial regulations, the SEC designated the three main ratings agencies (the same ones that we know today) as “Nationally Recognized Statistical Rating Organisations”. More quotes:
…the SEC worried that references to “recognized rating manuals” were too vague and that a “bogus” rating firm might arise that would promise “AAA” ratings to those companies that would suitably reward it and “DDD” ratings to those that would not. If a broker-dealer claimed that those ratings were “recognized,” the SEC might have difficulties challenging this assertion.
To solve this problem, the SEC designated Moody’s, S&P, and Fitch as “Nationally Recognized Statistical Rating Organizations” (NRSROs). In effect, the SEC endorsed the ratings of NRSROs for the determination of the broker-dealers’ capital requirements. Other financial regulators soon followed suit and deemed the SEC-identified NRSROs as the relevant sources of the ratings required for evaluations of the bond portfolios of their regulated financial institutions.
The Global Roll-Out
Because the rest of the world is heavily dependent on US markets for raising capital, and just as heavily influenced by US regulation, we all echoed their new ‘investment grade’ policies in our own financial regulation.
That is: we’re all collectively subject to the ratings agencies, because of fancy terms like “best practice”.
Some roll-out impacts:
- Most of the world’s money is managed by large funds (pension funds, investment funds, medical aid funds, sovereign funds, etc).
- Those funds are not free to just ‘make investments’.
- They have to make investments in “investment grade” securities. Not “speculative” ones.
- And in Credit Rating Agency terms: “Speculative” = “junk”
What that means:
- The standard story for credit ratings is: “the lower the credit rating, the higher the credit risk – and therefore, the higher the interest rate that the borrower will have to pay in order to compensate the lender for the extra risk”.
- But because of this new defining line between “speculative grade” and “investment grade” securities, there is a bit of an ‘interest rate’ cliff floating around somewhere in the middle.
Here’s a Venn Diagram of the main problem:
So when a bond goes from being investment grade to speculative grade, there is a much-larger-than-usual impact because those bonds are now ineligible for most of the world’s investors. And those investors have to sell-out of their bond investments pretty quickly in order to be legally-compliant in their own jurisdictions. So you get this:
When the “junk” downgrade happens…
So if South Africa’s debt were rated down to Junk status*, you can expect a sudden spike in interest rates. And even if there might be some anticipated sell-off in advance of a downgrade to junk, the real sell-off will still happen at and around the time of the actual downgrade.
*You’d need a junk rating from two out of the three agencies. And those two really need to be S&P and Moody’s – because those are the two reference ratings agencies in the World Government Bond Index (which is generally used as the investment benchmark). Fitch is for investors that have different benchmarks, I guess.
This then has further ripple effects, because:
- The ratings of corporate bonds of SA companies are linked to the ratings of the sovereign.
- So if SA government debt is downgraded to junk, it’s incredibly likely that the parastatals, the SA banks, and everyone else will drop down to junk as well.
As investors are forced to divest from those bonds, you’ll then have them cashing in their Rands for Dollars and shipping their money offshore. So the Rand will weaken. And in expectation of this depreciation, you’ll no doubt find foreign investors in the JSE cashing out their equity holdings in order to try and realise their dollar-returns in advance of it.
Whether they’ll manage that or not is a different question. But either way, if expectation of a rand depreciation causes a rand depreciation and a sell-off in the stock market, or if the sell-off in the stock market causes further rand depreciation, South Africa is still likely to end up with a weaker stock market and a weaker rand.
How are the bonds denominated?
To be fair, we really should be distinguishing here between:
- Rand-denominated Government Bonds; and
- Forex-denominated Government Bonds issued on the Eurobond market.
Rand-denominated Government Bonds are still all investment grade, even after S&P downgraded our Forex-denominated Government bonds*. And that’s because it’s not all that common to default on local debt – the government can theoretically arrange to have more Rands printed to repay that debt if it needed to. So it’s the Forex-denominated Government debt that’s currently at risk. And if you want to get some numbers on that, here’s a post that I wrote in October: Is that downgrade coming?
*Update: Fitch downgraded our Rand-denominated government bonds on Friday 7 April.
But this is probably just a technicality. I know that there’s a difference between the two – now you might know that there’s a difference after reading this. But any sort of downgrade will have ripple effects for us.
So putting that small side note aside, the rand depreciation means that there’ll almost certainly be some inflation. And the SARB will respond to that as it always does: by increasing interest rates.
As the costs of doing business and the costs of financing said business increase, corporate profits will continue to decline, salary increases will stay slow, and the fiscus will come under even more pressure as its tax revenues decline. So government will either increase taxes or cut back spending.
And if history is any indicator…
What all the above means for you
- The price of fuel will probably go up (as the Rand depreciates)
- Your monthly mortgage repayment will go up (when interest rates go up).
- Your monthly car repayment will go up (#interestrates)
- The cost of coffee, olive oil, prosecco and all those imported fun things will go up (#randdepreciation).
- You might well miss out on a bonus (as your employer’s cost of doing business goes up).
- Annual salary increases will be small, if they happen at all (same reason).
- You might even be retrenched (as above).
- And if you remain employed, it’s entirely likely that you’ll have to pay more tax (that’s already happening).
- Then if that’s not enough, expect more strikes as people get really unhappy about points 1 through 8.
And that situation will persist for some years. Unfortunately, once countries fall off the junk cliff, there’s a lot of self-fulfillment waiting at the bottom there. And climbing back up the cliff is arduous, and may require an IMF bailout.
So in two (very long) sentences:
“Junk status means that South Africa’s government, the parastatals, and South African corporates, will have lost access to much of the world’s investing money. Being cast out of the investment quality club means that: any first world comforts will be now be more expensive, anything financed with debt will cost more, the economy will stutter, jobs will be lost, and the South African taxpayers that are left will have to absorb the freshly-higher borrowing costs of the government’s debt – even as it might try to borrow more than before in order to keep up the levels of government spending that caused the cast-outedness in the first place.”
Gloom, eh? Let’s hope that Moody’s and Fitch feel differently to S&P.
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.