Thursday, 17 November 2011 - 20:00

 

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Credit Ratings: What Do They Mean?

News broke on Wednesday last week that the US credit rating agency Moody’s has downgraded the outlook on South Africa’s local and foreign currency government debt from stable to negative. This announcement resulted in the rand and local bonds weakening immediately on Wednesday, highlighting once again the significant effect these credit ratings have on market sentiment.

But how do these ratings work in practice?

There are three top credit rating agencies globally: Standard & Poor’s (S&P’s), Moody’s, and Fitch IBCA. These agencies assign ratings to most major investment instruments issued by both corporations and sovereigns, including short and long term debt obligations, securities and other loans. The ratings assigned are designed to inform potential investors of the risks associated with a particular credit issue, especially the issuer’s ability to repay the debt.

Moody’s uses a multidisciplinary or “universal” approach to credit analysis, trying to effectively combine qualitative and quantitative factors in their methods. A quantitative computer model provides an objective and factual starting point, and this initial rating is then discussed further by a diverse panel of credit risk professionals. This panel considers factors unique to the particular instrument, issuer, industry, and country in order to adjust the rating.

They follow these basic principles:
• Focus on the long term, looking through the next economic cycle or longer and not adjusting ratings based on business cycles and other short-term factors.
• Global consistency, ensuring that ratings are comparable across countries and industries and ensuring that a company’s debt rating can never exceed that of the country in which it is based.
• Level and predictability of cash flow, analysing strategic factors that drive the generation of cash flows that can be used to repay interest and capital.
• Reasonable adverse scenarios are analysed to try and determine if a company will still be able to meet its debt obligations under difficult conditions.
• “Seeing through” local accounting practices, in order to determine how different accounting practices can influence true economic value. Their focus when valuing assets are on future cash flows as opposed to balance sheet values.

The table below compares the 3 main rating agencies’ different ratings:

South Africa’s government debt currently carries an A3 rating from Moody’s, signifying they are upper medium grade obligations subject to low credit risk. Moody’s didn’t downgrade the actual rating on Wednesday, but rather the outlook which might indicate a future downgrade if certain factors in our economy don’t improve.

They indicated the following reasons for adjusting the outlook:
• Rising pressure from society at large, as well as from within the ANC, to ease fiscal policy and address SA’s high levels of poverty and unemployment. Spending more in order to deal with these socio-economic challenges could force debt levels higher.
• Moody’s expects economic growth to be lower than previously expected, limiting it to about 3% to 3.5% over the medium term. This is mostly a result of an overall weaker global economy. If this lower growth rate results in further increases in unemployment, risks of political instability may be increased.
• The ongoing debate regarding nationalisation of mines or other sectors may harm the future flow of private investment into SA.

The National Treasury responded quickly to these arguments, confirming that they are committed to a sustainable fiscal policy and low inflation targets. They also stated that they are managing their debt efficiently and although their budget deficit is widening they are not borrowing more.

It is agreed that the next two years will be especially challenging for SA’s political system, and the influence on our economy will be significant. Any downgrade will increase the rate at which the government can borrow, which in turn puts more pressure on the fiscus.

Kind regards,

Cor van Deventer
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Sources: Moody’s, Fin24

Thu, 17 Nov 2011

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