CAPE TOWN - Just what are credit rating agencies? Credit rating is a process of assessing and scoring the creditworthiness of would-be borrowers, on a standardised basis, to help lenders to decide who to lend to and on what terms.
Logically, if you were told that one borrower has a good credit score and another one has, by comparison, a bad score, you would lend only to the first borrower, or, if you did decide to lend to the second one, you would ask for a higher rate of interest, and you would lend a smaller amount. You might also require the loan to be repaid sooner.
Credit rating agencies carry out this process on institutional borrowers (governments, banks, parastatals, companies and other specialised commercial borrowers). Credit bureaus monitor the credit track record of individuals – the agencies do not rate individuals.
Internationally, Moody’s, Standard and Poor’s (S&P) and Fitch dominate the credit ratings industry, although there are smaller regional and national firms. In Southern Africa, a local firm called Global Credit Ratings (GCR) competes with the big players.
Firms seeking to provide credit ratings in South Africa have to be registered with the Financial Services Board. Moody’s, S&P and GCR are all registered here, but Fitch recently withdrew from the South African market (although it still provides ratings on RSA bonds in the international context).
2. What is the “business model” of the credit rating agencies?
When a company wants to borrow money by issuing a bond, it will often ask one of the rating agencies to rate the bond. The company issuing the bond will pay the agency to provide the rating.
Most of the income and profits of the rating agencies, therefore, come from fees that the borrowers pay to have their bonds rated. (The borrower believes that having a rating – a good one, in particular – will make it easier to borrow on favourable terms.)
It is sometimes argued that there is a conflict of interest, in that the rating agencies are paid by borrowers and therefore have an incentive to give their “customers” good ratings. It is thus important that the rating agencies operate with high standards of diligence and integrity. In many countries, including South Africa, financial market regulators supervise their activities to ensure that they do not, for instance, display bias by giving high-paying customers better ratings.
As some investment managers point out, the conflict of interest here is really no greater than when a company hires an audit firm to audit its financial statements, or when a pension fund pays an actuary to assess its financial soundness.
The agencies also provide ratings for bonds issued by governments – so-called “sovereign ratings”. They are not paid by the governments. They do this (without payment) because having a view on the relative creditworthiness of a country’s government debt makes it easier to assess the relative creditworthiness of the country’s other borrowers, such as banks.
3. What is the controversy over the rating agencies’ role in the global financial crisis?
In the years leading up to the so-called global financial crisis of 2008/9, the investment banks were earning large fees by bringing to the market what we might call “fringe” credit instruments, such as specialised bonds backed by pools of residential mortgages or consumer loans, and structured in innovative and complex ways.
Investors, such as large pension funds, were excited by the high interest rates paid by these specialised bonds, but were nervous about their complexity. The investment bank sponsoring the bond would, therefore, choose a rating agency to give it a credit rating. The investors would be comforted if the bond had a good credit rating, such as AAA (triple-A), from a reputable agency, and would be more likely to invest.
During the financial crisis, many bonds that had been given good ratings went into default. (This highlights that a credit rating of AAA is not the same thing as a guarantee of repayment.) Both banks and investors had been far too optimistic about the quality of the loans underlying these complex bonds, and repayment rates were much worse than expected.
Blame was cast in various directions as pension funds and others who had lost money through this fiasco looked for scapegoats. While the investment banks suffered the greatest reputational damage, the credit rating agencies did not escape.
Accusations were that they were over-confident and had over-estimated their own expertise in assessing such complex debt instruments, or that they had grown too close to the investment banks that were, in effect, their customers. The rating agencies were certainly competing for business from a fairly limited pool of clients, which may have sharpened the potential for conflicts of interest.
Both Moody’s and S&P faced actual or threatened lawsuits from lenders and from the authorities in the United States, and ultimately paid large settlement amounts in the US. This led to heightened regulatory oversight of the rating agencies, as well as their own efforts to “clean up their act”. Paradoxically, greater regulation has made it harder for new firms to compete with the established agencies, which has strengthened their competitive position. An example is Fitch’s recent decision to leave the South African market to Moody’s, S&P and GCR.
4. What are “sovereign ratings” and why are they important?
All governments have to borrow money from time to time. Most governments have a significant amount of debt outstanding at any time. Governments are called “sovereign borrowers”, as distinct from commercial entities that are “corporate borrowers”.
Governments will borrow in their own countries from domestic investors, such as pension funds and insurers, as well as from private savers. The bonds that a government issues in its domestic market will be denominated in its own currency – so the RSA Government bonds held by most South African retirement funds are of course denominated in rands. (Foreign investors can, and do, also buy rand-denominated bonds.)
Governments will also often borrow from foreign lenders. These borrowings might be denominated in the home currency, but may also be issued in a currency such as the US dollar or the euro. The reason is that some lenders in the US may be willing to lend to the South African government, but may prefer to lend in dollars so that they do not carry the risk of the rand weakening.
It is generally agreed that bonds issued in a government’s own currency are safer than those issued in a foreign currency. This is because when the government promises that it will repay its debt denominated in rands, in extreme circumstances it can always print more rands in order to do so.
However, if the government borrows in dollars, it is unable to print dollars to pay back this debt; it would have to use rands to buy dollars (or, often, raise a new dollar-denominated loan to settle the one that is due for repayment).
As a result, the rating agencies distinguish between “global scale foreign currency” ratings, “global scale local currency” ratings and “national scale” ratings. The first two are to allow international comparisons, and national ratings are to allow comparisons across borrowers within a country, relative to government debt in that country (which normally has a national scale rating of AAA). On the global scale, a government’s local currency rating will sometimes be better than its foreign currency rating.
5. What is a downgrade?
The rating agencies each have a standard notation to assign ratings to borrowers. S&P, Fitch and GCR use the same notation, with AAA the highest and therefore the best rating. Ratings of BBB– (BBB-minus) or above are usually described as “investment grade”, while BB or B ratings are sub-investment grade, commonly referred to as “junk” or “high yield”. In the agencies’ judgment, investment-grade bonds are very or moderately safe investments, while sub-investment-grade bonds are distinctly more risky.
A C rating indicates that the rating agency believes the borrower is close to defaulting, and a D rating indicates that the borrower has defaulted.
Over time, the rating agencies will review the ratings that they assign to borrowers, and borrowers may move up or down the scale. Moving down the scale – for example, from AAA to AA – is a downgrade. More critically, moving from a BBB– to a BB rating (BB+, BB or BB–) is a downgrade from investment grade to “junk” status.
The various agencies each make their own assessments and give independent ratings where they are assessing the same borrower. Often, their views will be largely the same, but sometimes they differ, although the differences are usually small.
6. Why is a downgrade to “junk” status important?
By and large, lenders are not obliged to take account of the rating agencies’ ratings – they can ignore them if they wish. (There are exceptions, which we will explain below.)
In fact, one of the lessons of the global financial crisis has been that investors – lenders – should not slavishly follow the agency ratings without thinking for themselves. In South Africa, regulation 28 of the Pension Funds Act states explicitly that a fund and its investment managers must not rely on credit agency ratings in isolation when making lending decisions, and should carry out their own due diligence.
Credit agency ratings will, therefore, be a factor that investment managers take into account when they decide the terms on which they are willing to lend money, but there will be other factors too, including the manager’s own assessment of credit risk.
Even so, investors will tend to pay attention to a down-rating, particularly when more than one agency downgrades the same borrower. This is obvious – the downgrade does not happen in a vacuum, but
reflects concerns that will usually be shared by many investors.
If a country was generally rated BBB last month but is down-rated to BB+ (sub-investment grade), while other countries retain their BBB ratings or better, the agencies are saying that, in relative terms, the country’s credit risk has increased. Most likely, this is also the perception of the investment community in general.
The effect will be that lenders are less keen to buy the country’s bonds and will ask for better terms (a higher interest rate, or earlier repayment) than they would have done previously. This makes it more expensive for a government to borrow.
There will be a knock-on effect for other borrowers, such as banks and large companies, particularly if they are trying to borrow from foreign investors: they will also have to pay more – for example, via higher interest rates.
7. How does South Africa compare to other countries?
Countries such as Germany and the US have the best credit ratings. Germany is rated AAA for its foreign currency debt by all three of the big agencies.
Of the other BRICS nations, China and India have investment-grade ratings, while Brazil and Russia are generally rated below investment grade. (Fitch has a BBB– rating for Russia.) Turkey, another country to which South Africa is often compared, is also below investment grade, as are Nigeria, Egypt and Kenya (both in the single-B band). Botswana has a single-A rating.
8. Will the downgrade lead to disinvestments by foreigners who have bought our government bonds?
To some extent, yes. However, as noted above, investment managers are not slaves of the rating agencies but make independent decisions.
Managers also try to anticipate future developments. The rating agencies can be slow to make decisions, and so the managers may act in advance of ratings changes that they know or suspect are on the way. In other words, some selling may happen even before downgrades are announced.
In addition, the prevailing global investment climate is generally positive for emerging-market bonds (a category into which South Africa falls). This is because the interest rates paid by bonds issued by developed-world borrowers such as the US, the United Kingdom, Germany and Japan are extremely low. Investors, therefore, remain willing to take some risk by investing in bonds from countries such as Brazil, Turkey and South Africa, because these pay significantly higher interest rates.
Having said that, there are some technical issues that could give rise to some “forced selling” of RSA bonds.
Some investment managers may have restrictions imposed on them by their clients (such as the large pension funds) that prevent them from holding sub-investment grade or “junk” bonds in their portfolios.
Ideally, if the bonds were investment grade when the manager first bought them, the clients’ rules will not force the manager to sell these bonds when they are downgraded, but the manager may not be allowed to buy more of them. But this would still tend to reduce the demand for RSA bonds once they fall to “junk” status.
Second, the various firms that compile indices of bond market performance have their own rules as to which bonds to include in their indices. There are various indices of the performance of investment-grade bonds. At some point after RSA bonds fall to “junk” status, the index construction rules will mean that the RSA bonds are removed from the index.
Investment managers that are benchmarked against well-known indices, such as the Citigroup World Government Bond Index and the JP Morgan Global Government Bond Index, may not wish to hold bonds that no longer form part of these indices, or their investment mandates may prevent them from doing so.
More importantly perhaps, if a bond portfolio aims to track the performance of, for example, the Citigroup index, the manager will only want to hold the bonds that make up the index, in the correct proportions, and will need to sell bonds that are removed from the index.
The extent of index-tracking in the global bond market is hard to assess, but there are estimates that some R100 billion of “forced selling” of RSA bonds could be looming if, or when, the country is removed from the investment-grade indices.
The timing and impact of this forced selling is uncertain, and if the demand to invest in emerging-market bonds remains high, the sellers might quite easily find new buyers for these RSA bonds. But this cannot be a good thing.
9. What has actually happened to our bond market?
There was a sell-off in the local bond market in the last week of March 2017, and the rand also weakened significantly.
However, since then the rand has been reasonably steady against the major developed-world currencies, and the bond market recovered well during April. As noted, this may be more a result of the prevailing global environment and foreign investors’ hunt for higher-yielding investments, rather than a response to the downgrades.
Of course, investors may be awaiting further developments. Brazil’s debt was downgraded to “junk” status by early 2016, amid the political instability leading to the impeachment of President Rousseff in September 2016. However, in the months following the downgrades, Brazil had net inflows of bond investment, and the prices of government bonds actually rose quite sharply.
Again, this is probably partly due to the global environment of yield-chasing, but also because investors may have been anticipating what they saw as positive political developments in Brazil. The same may apply to South Africa – investors may be optimistic that the current political uncertainty here will resolve itself in an investor-friendly way.
10. So the downgrades are not a bad thing, then?
The key point is that the market’s response to a credit downgrade is hard to predict, and may not be the obvious one that we expect. The reasons for this are varied. We have pointed to some of them above, but perhaps the most important is that investors look forward and try to anticipate future developments.
Overall, however, the net effect of the downgrades is to make South African bonds less “competitive” when measured against those of other countries, and therefore to make the cost of borrowing, both for our government and for other borrowers (ultimately including ordinary citizens) more expensive than it would otherwise have been. The possibility of widespread forced selling of our bonds, in particular, is a negative factor.
The reasons behind the downgrades are also important. These include the sluggish local economy, deteriorating public finances including those of many state-owned enterprises (SOEs), poor governance at many SOEs, and uncertainty and even a degree of paralysis in government policy.
The downgrades cannot be good.
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Erich Potgieter and Martin Jankelowitz are senior investment consultants at Willis Towers Watson.
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