By George Herman, Citadel Director and Chief Investment Officer
Bloomberg news agency recently published an article stating that South African bonds were now seemingly “junk” – a word which is loaded with negative sentiments.
In turbulent times such as these, it is essential to remain calm and objective, and not to become embroiled in such emotional judgements. 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.
The Bloomberg article 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”, however, 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”.
Global ratings agencies are like 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. There are two messages to take from this 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.
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. 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.
When a country such as South Africa now lands on this borderline where some agencies rate us within the investment grade universe and some outside, and some for foreign currency debt and some for local currency debt, 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.
At Citadel, we appreciate that defaults by countries in the top bracket of non-investment grade are only marginally higher than those in the lowest bracket of investment grade, so the actual difference in absolute credit risk is marginal. However, the shift from investment grade to non-investment grade causes a much greater adjustment in yields than the numerical assessment of risk suggests. Falling out of the investment grade universe is costly, but it is also not the end of the world. The risk of South Africa dropping out of the investment grade universe has been with us for over a year and is no surprise to us at all. We have been advocating an underweight stance to South African bonds for a long time.
It is also exactly why times like these offer opportunities. When other investors become forced sellers of South African bonds, we will have the opportunity to create attractive assets for our portfolios for many years to come. This is a good example of where active managers can effectively reduce risk prior to an event and, in so doing, protect capital and enhance returns. By comparison, the passive investor will now be forced to sell at a massive loss.
While current local rhetoric is relying heavily on the term “junk”, you will notice that Citadel does not use this description at all. No investment is “junk” simply because some foreign investor can no longer invest in it. As South African investors, our home market still provides opportunities, despite some critics now scoring us lower than before. For us at Citadel, the movie goes on and our task of managing our clients’ wealth has not changed. The only thing that has changed is the movie’s rating.