‘Junk’ wrong word for South Africa credit status

By Thandisizwe Mgudlwa

Cape Town – On the back of South Africa’s down-grade by rating agencies, speculation is rife as to what does this mean for the consumer and the economy.

It is also argued that much of the interpretations and commentary flowing around will not pass as accurate and even professional opinion.

That is why is becomes highly appreciative when an expert on such issues provides an up-to-date research and professional account of what a down grade would mean for a country like South Africa.

This time around, the honour is bestowed by George Herman, the Citadel director, who argues that ‘junk’ is not a word used by the credit agencies.

Herman strongly suggests that the word ‘junk’ should be banished from the investment lexicon as it is loaded with negative sentiments.

He said it is essential to remain calm and objective in turbulent times. “Ask yourself: were South African bonds ‘junk’ 10 days ago? No. Has our probability of default increased meaningfully since then? The answer, again, is no.”

Herman highlighted a Bloomberg article which made reference to the recent credit rating downgrades to ‘sub-investment’ grade by Standard & Poor’s and Fitch, a level often touted as ‘junk’.

‘Junk’, Herman said, is not the word used by the credit agencies.

But it is merely a label developed among regulated investors who are not permitted to invest beyond ‘investment grade’ securities or countries.

“And yet the word carries tremendous weight and emotional currency, most of which is an inaccurate reflection of what investment grade or sub-investment grade actually means.

“In short, it is a poorly defined term that should be banished from the investment lexicon. The attractiveness of an investment is determined by the objective of a client or investor and the mandate that client has given the financial manager. That mandate may exclude many countries or asset classes and that exclusion doesn’t make those particular investments ‘junk’.”

The Citadel director has likened global ratings agencies to film critics.

Herman notes that they (ratings agencies) have a published and pre-determined set of credit scoring criteria and aim to identify risks with those scores when giving their outlook.

“You may decide that you’ll only watch movies rated above a certain level by a certain critic, because you agree with the criteria, and that’s a perfectly acceptable way of filtering the entire universe of movies to suit your particular taste,” he said.

The analyst further pointed to two takeaways from the analogy, (a) If this particular critic rates a particular movie at a score lower than your cut-off point, it doesn’t make that particular movie junk; b) If this particular critic rates this specific movie lower than a score generally associated with a good movie, it serves absolutely no purpose criticising the critic.

Herman also remarked that global investment firms require an independent, objective party to rate or score the entire global fixed income investment universe.

Their mandates are then set up to include only investments higher than a specific score and this universe of investments is then investable for them.

Global economic analyst, attest that over the years regulations for global pension funds have been standardised and, in so doing, this has created what is now known as the investment grade universe.

“This is merely a line in the sand, since a distinction or limit needs to be set somewhere,” agrees Herman.

“On the continuum of risk, the difference between the lowest ranked security in investment grade and the highest ranked security in the non-investment grade list is absolutely marginal and most definitely not as binary as the inclusion or exclusion would suggest.

“The one investment can’t be described as perfectly acceptable while the next as ‘junk’. It is merely outside the predetermined universe of a certain set of investors,” the analyst said.

Herman explains that the country faces a cliff risk, when South Africa lands on this borderline where some agencies rate the country within the investment grade universe and some outside, and some for foreign currency debt and some for local currency debt.

“Stay within investment grade and the entire world can invest in your bonds. Move one notch lower and suddenly very few global investors are allowed to invest in your bonds. This single notch rating change thus poses the reality of rising risk premiums and, in this instance, higher bond yields.”

He states that the shift from investment grade to non-investment grade causes a much greater adjustment in yields than the numerical assessment of risk suggests.

Herman adds that falling out of the investment grade universe is costly, but it is also not the end of the world.

“As South African investors, our home market still provides opportunities, despite some critics now scoring us lower than before.”

Meanwhile, despite the recent downgrades by ratings agencies of South Africa’s sovereign credit rating, the country could continue to improve its attractiveness as a Foreign Direct Investment (FDI) destination.

This view is a consensus among leaders of some of the country’s most credible companies, who participated in a panel discussion hosted by Sanlam Private Wealth and Financial Mail on Thursday evening, last week.

Sigma Capital executive chairperson Phuti Mahanyele, Naspers Group CEO Bob van Dijk and Lonmin CEO Ben Magara, insisted that apart from a country’s sovereign credit rating, investors look at a basket of factors.

These include whether or not the regulatory regime can provide reliable long-term protection on investments. Van Dijk indicated that Naspers invests in companies with the potential of substantial growth over the next few years, including those in ‘challenging’ markets.

“We’ve invested a lot of capital in Brazil, for example, which has also been downgraded to junk status. But we don’t look only at a country’s credit rating. For us, the main question is around the business opportunity, but it’s also about being comfortable that an investment will be protected over the long term.”

May 2017
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