Citadel director, George Herman, argues that ‘junk’ is not a word used by the credit agencies and should be banished from the investment lexicon as it is loaded with negative sentiments.
Herman 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.”
He 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 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’.”
Herman likened global ratings agencies to film critics. They 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 pointed to two takeaways from the analogy:
- 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.
- 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 said 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.
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,” Herman said.
“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.
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, Herman said we face a cliff risk.
“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.”
Herman said that the shift from investment grade to non-investment grade causes a much greater adjustment in yields than the numerical assessment of risk suggests.
He stressed 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.”