Mark Ingham: Exposing junk – dispelling ratings agency myths, mumbo jumbo.

The Big Three ratings agencies have come and gone. And, for the moment at least, they’ve left South Africa’s credit rating at “investment grade” and issued their usual dry, complicated reports that warn, so diplomatically, that SA has entered last chance saloon. Just like they’ve been doing for a couple years now. Independent investment analyst Mark Ingham wrote a rather scathing blog accusing pundits of sensationalising the “junk bond” story. He reckons most of the commentators missed the entire point of what ratings agencies do and how they affect our lives. So I asked him to please explain, setting the stage for a fascinating discourse on dispelling financial myths and mumbo-jumbo. – Alec Hogg

This special podcast is brought to you by EasyEquities. Mark Ingham is an independent Investment Analyst and as usual he joins us now for an update on topical issues and investment affairs, and if there has been one issue in most investor’s minds or front and centre of people’s minds in the past few weeks, it has been rating agencies. Mark, you’ve been taking a close look at it and there really are three rating agencies that matter.

Yes Alec, that’s true. We have S&P Global Ratings, Moody’s Investor’s Service and Fitch Ratings (the big three). There are others, but those three, (it depends how you measure these things), have roughly 93 percent of the ratings market.

They were in South Africa recently to give South Africa a rating. Before we go into the details of that, what I found interesting from the note that you published on Easy Equities website is that they actually get paid by the organisation that they do the rating on. That sounds like a bit of a conflict of interest there.

It’s been an issue of debate for years Alec and there are those who criticise the revenue model, but nobody has come up with a better suggestion as to how you actually do this. Let’s just remind our self, these are commercial entities, they have a full profit motive, they’re not charities and there is a crit rightly or wrongly that questions whether their objective, whether there’s conflicts of interest, if there’s sufficient safeguards in place. The agency has received payment for their services from an issuer that request the rating, or for those who subscribe to what they do. The issue of a pay model is one in which the rating agency charges issuers a fee for providing a rating agency’s opinion and that is the case particularly with corporates. Then that information is made available in the public domain.

Let’s look at the South African one. We know right now that it’s critically important to South Africa that its rating is held above investment grade for all kinds of reasons. Wouldn’t there have been some temptation, just some perhaps because South Africa in this case is the paymaster for the rating agencies to say “Well, let’s go a little easy on them”?

Organisations actually sort of solicit ratings and they do that so that there’s a credible yardstick and that enables the issuers, be they governments, local authorities, or corporations to have ready access to capital markets domestically and abroad and it’s fixed the pricing of that. In their latest rating S&P were quite clear that the credit rating had been solicited and that the rating entity, which in this case is SA government, had been part and parcel of the whole credit rating process and so to do that Alec, they opened their books and the people involved at the rating agencies can speak to pretty much whoever they choose to and in fact, they do get access to information that’s not always readily available in the public domain.

It’s in the interests of the rating agencies to ensure that they too have a credible position and so although from the outside one may think that there is the temptation to go easy, the fact of the matter is that this is not just an absolute situation that they’re rating, they’re looking at the relative position of one country in this case, against others and so if you compromise with respect to one country there’s a domino effect that goes right through the rating process and therefore that would bring into question the actual credibility.

Let’s also remind ourselves that there’s a long history, particularly when it comes to sovereign, of the credit agencies downgrading to sub-investment grade. In the parlance of S&P, they have investment grade and they have a speculative grade .We only need to think of the likes of Argentina for instance, Brazil, where those countries have been cut to speculative grade. So in that case the agency was being consistent in the way that it applied the metrics that it uses to determine the outcome.

I guess the good news as well is that they had a terrible shock in 2007, 2008 with the global financial crisis and it’s unlikely given the hiding that rating agencies took at that time that they’re going to go and repeat the same mistakes. Let’s give them the benefit of the doubt and say they’re all acting credibly. How did they then come to the conclusions that all of this concern that we South Africans are seeing around the country is not sufficient to knock the rating back to junk?

Well, junk is used in common parlance, the rating agencies tend to issue that, but junk would effectively mean and seeing as we’re on S&P, that would mean falling below a triple B minus into double B plus and so we in fact, within that category of investment grade, I should point out Alec that the long-term local currency debt rating is triple B, which is two notches above sub investment grade and the overseas rating if you will, foreign debt rating is one notch above. They’ve done a fairly comprehensive process here. This happens every six months. National Treasury have too in fact published pretty much what they’ve said, they’ve acknowledged the strength, they’ve acknowledged the weaknesses that have been pointed out and they’ve also emphasised what needs to be done to put shoulder to the wheel to ensure that the country retains the right rating.

Standard & Poor's HQ.
Standard & Poor’s HQ

These are very dry people, Alec, you know. I think typically one would think that they would act without bias and I think given the very comprehensive rating processes that these companies have, they aren’t all the same, they do differ one from the other, but by and large the conclusion is broadly the same. You can add the situation in which one rating agency can rate a country sub-investment grade and the other one can rate it investment grade, but it is a thorough process.

I think as you rightly point out Alec, the events of 2008, 2009, I think were a wakeup call for everybody in the financial market and I think that particularly the way we assess credit quality and indeed I have in front of me a 663-page report from the United States, which is the financial crisis (it was a report issued in the United States). It tackles exactly the point that you raise and how everybody can be better prepared in the future, so I think there is some positive learnings that came out of 2008, 2009 and I think those learnings have become increasingly incorporated in the way the rating agencies (which have been around for many, many decades) assess the credit quality of companies, governments and so forth.

All right, well we won’t go through the 660-page report, but we’ll believe that you have done so and also all the detailed results which of course are available publicly now through the internet. From an investor’s perspective how seriously should we be taking these ratings and particularly for interest rate stocks and for banks, which clearly are most vulnerable to a downgrade or indeed most at benefit when there hasn’t been one?

Alec, I think what’s important to people to recognise is that credit ratings are an opinion about credit risk and it does not indicate investment merit. I think that’s an important sort of distinction to actually make. The ratings agency through both mathematical modelling, the assessment of data, forecasts and from the subjective opinions that they would obviously make through the interaction with senior government people and others, it really is their opinion about the ability and willingness of the issuer to meet its financial obligations in full and on time. They address credit quality first and foremost and the relative likelihood that the issuer may or may not actually default and I think we also need to recognise that there’s no absolute measure here, we can’t look at the future and predict accurately, so it’s not intended as a guarantee of credit quality or an exact measure, but it is the best we have.

So it’s a tool in other words, it’s a tool in your armoury as an investor, you pay attention to it, but don’t actually bet the house one way or the other.

That’s correct. Any investor, be you investing in bonds or stocks, you can use the credit rating as part of your investment decision-making process, again bearing in mind that it’s not an indication of investment quality, its credit quality. The rating doesn’t signal the suitability of whether Sibanye Gold is a great investment or First Rand, so you would use this as you rightly say Alec, as part of your toolkit. What’s very useful for government is that it’s an external and largely credible litmus test of what they’re up to. Now some governments may take exception, but it is an external check on them and again I think it’s the best that we have. Ultimately, of course it’s investors voting with their wallets that make the ultimate decision.

There was a criticism, I think, post-2008 and 2009 that these ratings agencies were shutting the stable door after the horse had bolted and there’s an element of that being correct. Again I think it gets back to the point that we can’t forecast with any degree of 100 percent accuracy, but I think if you look at this as a yardstick and then use that as part of a number of aspects of the way you investigate your exposure, I think you won’t go far wrong. Another thing to point out is that the past trustworthiness of a country, for instance, or a corporate doesn’t necessarily indicate that, that will be the case in the future and I think virtually the whole world at the moment and particularly in the developed world, one could argue that the quality of credit is perhaps lower than it was 10, 15 years ago, even though bond yields are at record lows and in sometimes minus.

Getting back to what we heard last week from the ratings agencies how does this play out for interest rate sensitive stocks in South Africa?

South_African_StubYes, it’s very important. Ultimately markets do price ahead of what the credit rating agencies come out with and I think we’ve seen an element of that in the last number of months, so when all three had issued their more recent ratings we didn’t really see the bond market react that much. I think that markets do tend to price ahead, they sometimes price too much on the downside, too much on the upside. What we’d also seen is a jockeying in portfolios. In other words, some investors that possibly thought that they were skating a bit too much on thin ice with respect to their exposure to South Africa, probably would have sold out in advance and we’ve seen fairly active trading activity in the bond market over the last number of months.

I think those that took a view that the fundamentals weren’t perhaps as bad as some of the newspaper headlines make out, think “Okay, nine percent, even allowing for currency risk isn’t a bad thing and we’ll take that, thank you very much”. I think it’s worth pointing out that we do have quite a vigorous amount of interest in South African domestic bonds from overseas investors. They account for approximately 35 percent of the total domestic bonds held and I think that’s to a certain extent a vote of confidence in the liquidity and the depth of the markets that we have.

Therefore the rating is quite important because it does give people a sense of relative (I guess you could say), certainty, but I think also given the fact that we are exposed to a number of foreign investors, they have to have a degree of confidence and therefore, that affects the degree to which bonds are priced. And as we have discussed before, banks are particularly sensitive to the cost of money and we’ve seen some fairly big volatility in the bond market, particularly since December 2015 when bonds spiked by 200 basis points. That’s calmed down quite a lot and the ten-year bond at the moment is about nine percent, just slightly under that and that hasn’t moved much in the last three or four months, so I think there’s a relative calmness that’s descended on the market for the time being.

Well, hopefully those 200 basis points in two days, the consequence of Nenegate never visits the country again because that can’t be much fun for people operating in the bond markets. Mark you said it’s a relative game and relatively speaking, when foreigners are looking too, it mustn’t be forgotten that bonds are issued by governments who raise money to invest hopefully in infrastructure projects and the other side or the alternatives they have is Russia, Turkey, Brazil. They’re not looking terribly sweet themselves, so from that perspective I guess the relative game is in South Africa’s favour, particularly that we retain this investment grade.

I think so. Also we don’t have much foreign debt; only ten percent of South African government outstanding debt is overseas debt.

Well, in Dollar denomination, there’s a lot of overseas debt in foreign investment.

Well, yes, so of the $2.2trillion in debt, approximately $230bn in foreign currency denominated debt. So that’s relatively small, it’s ten percent of the total government debt stock is foreign currency denominated and we need to remember that when talk about junk goes around because South Africa is under-borrowed from a foreign currency point of view and we’ve seen international investor involvement in Rand bonds, fairly resilient and I think that’s very important to actually bear in mind that the bulk of debt is in our own currency and South Africa can issue its own sort of currency and I think that’s a very important point to make.

Many of our international peers have substantially higher foreign currency debt and therefore from a relative point of view that’s why the pricing of South African debt is very competitive. In other words it’s lower than Turkey for instance and the various other countries that we tend to compare ourselves against. So what you find is that South Africa is rated investment rate by all of the big three, Russia is another country that falls into that peer group.

Russia and Turkey are rated investment grade by Fitch, but they’re sub in grade by S&P and Moody’s and Brazil, (and I think we tend to compare ourselves most with that country, Alec), that is rated sub-investment grade by all three. Therefore, on a relative basis I think we don’t stack up too badly and I think particularly given the fact that the bulk of our government debt is domestically domiciled even though approximately 35 percent is held by foreign investors, I think that’s an important safety valve.

The economy has been well-managed to a point, up to a period in time and of course it’s getting a lot more difficult now, but we know all about this. Just going to the way that the ratings agencies came out with the numbers, is this going to be positive or negative for banking shares?

I think the fact that we’ve seen the ten-year bonds go from, let’s call it about the 8.6 level to about 8.9 at the moment, they were pricing in advance, I think a slightly negative outlook and Fitch came out and revised their outlook to negative from stable and Moody’s pretty much left things as they were, S&P also indicated that there was a rather more downbeat outlook than there was before. That revision to negative on the outlook I think does give pause for thought.

Image courtesy of Twitter

There is a carrot and stick element to this, and I think government is aware of that, National Treasury particularly is aware of that. The rating agencies make suggestions as to what is needed to improve the situation and all of them have done it this time. Notably what they’ve all done this time is raise the issue of the politics and arguably the toxic politics although they tend to be very much more polite about these things, but they have issued a veiled warning that if certain metrics don’t improve then they would reassess going forward. Treasury has taken note of that and so I think the bond markets have priced in and the degree of expectation of the status quo prevailing with a mildly negative outlook.

Let’s not forget luck can often play quite a big part in these things too, but if I think the practical suggestions are followed and government keeps its fiscal line in order, then the next round should arguably come out with a fairly similar thing, short of us shooting ourselves in both feet twice. So I think we’ll go through a period of relative calm now, but I think there will be hawk eyes on economic delivery and the degree to which the ratings agencies can be kept onside if you will. Another positive in the last year is that, as often happens in South Africa, we look into the abyss, we don’t quite like what we see and we step back and I think we should be grateful that a combined effort by a whole host of interested parties, not least business unions, government and various other parties that have certainly come round and I think there’s been a lot of effort expended.

Treasury have been the first to acknowledge that the work doesn’t stop here, it actually starts, but I think there’s a clear focus by all in South Africa including the proverbial man in the street. What needs to be done, and I think these are very practical debates as well because it brings economics and the consequences of misgovernment into the public domain, people talk about it, people understand what needs to be done and I think a well-informed populous in turn helps feed positively back into the state and what the state is doing.

That’s good, sound, stable kind of outlook, we can sit back, understand these things, and they’re never quite as dramatic as some people like to portray them. I would like to close off with that because you had some rather scathing words in your piece that you wrote for the site about pundits. You have a rather low opinion of them, why so?

Alec, don’t believe pundits.

Don’t get me started.

A Pundit, who isn’t worthwhile listening to, far be it from that, but I think we have to bear in mind that sometimes there is a lot of cat calling, a lot of armchair know-it-all type stuff and bear in mind that rating agencies don’t talk to the general public every day about what they’re up to. They keep their cards very close to the chest, they’re dry technocrats, and I think there’s much interpretation as to what they’re up to rather than just seeing them for what they actually are. There’s a fair amount, and you see it not just in South Africa, but around the world. I think with the 24-hour news media we have today there’s a certain amount of second guessing as to what is going to happen and in fact, we’ve had this for months on end now. It was almost beyond certain that there would be a downgrade six months ago.

That didn’t happen, well it was going to happen in the next six months, and then that didn’t happen. I think the debate is fairly healthy to have and I think South Africa particularly has a very vigorous and healthy media and a sort of economist, everybody puts in their few cents’ worth, but I think ultimately the reality of what the rating agencies have come out with was perhaps a little different to what the more hysterical thoughts were as to what would happen. I think also people often place too much emphasis on the politics around it.

There is a myriad of different factors that come into play with these agencies and Zuma’s antics or SAA’s carrying on is but one small part of the total piece, if you will. So I think we need to see it in the right sort of perspective and if that debate can bring government into a clear line of sight as to what the general public are actually concerned about, then I think that’s actually very positive. I’m not necessarily convinced that the hysteria that’s sometimes whipped up around it, is that good.

Mark Ingham is an Independent Investment Analyst and this special podcast was brought to you by EasyEquities.

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