London - Investors are starting to price the risk of Russia's credit rating falling to junk if Western sanctions and Moscow's response plunge the economy into recession and deplete its $450 billion (R5 trillion) reserves.
Being investment grade - at least BBB minus from Standard & Poor's and Fitch or Baa3 from Moody's - allows a borrower to tap a far wider pool of investors, and losing that ranking would be likely to cause big outflows from Russian markets.
Moody's, which rates Russia Baa1 or three notches above junk, said this week that the latest sanctions were credit negative.
Fitch has a negative outlook on its BBB rating, two notches above junk, while S&P rates Russia BBB-minus with a negative outlook.
But investors are already treating Russia as being as risky as junk.
Bond market investors typically use CDS to insure against non-payment of debt, but they are also often used as a proxy to gauge how risky an entity is, which is why there is a close relationship between credit ratings and CDS.
The higher the CDS spread, the riskier the credit is deemed to be.
Russian CDS are higher than those of Indonesia, Brazil and Turkey, whose ratings, while investment grade, are lower.
“Russian CDS are extremely cheap compared to its ratings; that points to a move by the ratings agencies,” said Ishitaa Sharma, an emerging markets strategist at Citi.
“We think the agencies are going to do the catch-up now.”
For instance, Russian five-year CDS trade at around 250 basis points, according to Markit, or more than 100 bps above Brazil's, even though it is rated slightly higher.
That means it costs $250,000 a year to hedge $10 million worth of exposure to Russia for five years.
The cost for Brazil is $138,000.
The contrast is even more startling with Hungary, whose CDS trade at around 150 bps despite its junk BB/Ba1/BB plus ratings.
With public debt levels of 10 percent of annual output, half a trillion dollars in currency reserves and a current account surplus, Russia, arguably, does not deserve to be rated junk.
But David Hauner, head of fixed income and economics for Emerging Europe, Middle East and Africa at Bank of America/Merrill Lynch, said ratings were also determined by the direction of the economy and debt levels.
“If you look at the balance sheet alone, Russia's rating should be even higher,” Hauner said.
“The key is the uncertainty coming from a deteriorating business climate and the risk of more sanctions. So while a downgrade to junk may not be vindicated by current numbers, the agencies might fear the uncertainty would justify it,” he added.
Implications could be huge.
JPMorgan calculated earlier this year that a one-notch ratings downgrade causes a roughly 20 percent increase in borrowing costs.
A fall into junk will fuel outflows from funds that can only invest in investment grade securities, and the ejection of Russia from the investment grade portion of benchmark bond indexes such as JPMorgan's GBI-EM or EMBI Global.
“A downgrade to junk would have material impact in terms of flows. The implications are bigger than for a normal downgrade; it increases the hurdle rate for investments,” Hauner said, referring to the minimum rate of return required by an investor. - Reuters