What an Australian ratings downgrade means for fixed income investors

Speculation over a downgrade to Australia’s S&P sovereign credit rating is ramping up as the 2017 Federal Budget announcement approaches. Will stronger commodities prices, growing export incomes and the upcoming small business tax cuts be sufficient to appease the S&P? There are numerous credit ratings tied to Australia’s sovereign rating and a downgrade would impact various segments across the domestic fixed income market. Our fixed income team share their varied perspectives on the knock on impact of a sovereign downgrade, based on their sector coverage under our ‘Balanced Risk’ approach to portfolio management which values diversity in thought and timing in risk entry.

Ratings Overview and Issues – Toni Spencer (Head of Credit Research) and Stephen Halmarick (Chief Economist)

Australia’s AAA rating has been on negative outlook with S&P since July 2016. S&P was prompted to take this action by their view that the government’s inability to repair persistent material budget deficits was becoming inconsistent with Australia’s high level of external indebtedness. Post the 2016 election, S&P considered the government would be challenged to pass revenue and expenditure measures through both Houses of Parliament, and as a consequence, the forecast return to a balanced budget by FY21 was in doubt. Further, S&P had a more pessimistic view on commodity prices, inflation and wage growth than the government, and so prospects for budgetary improvements were weaker than previously assessed. As noted above, the improvement in commodity prices and the government’s ability to get some policy measures passed through the Senate has taken some of the immediate pressure off Australia’s AAA ratings. But substantial expenditure reform still looks to be challenging, given the current make-up of Parliament, and we believe a sovereign downgrade is still likely over the course of the next year.

Sovereign Bonds – Stephen Cooper (Head of Australian Fixed Income)

Whilst much is likely to be made in the press and Parliament in the event of a sovereign rating downgrade, the impact on government bond yields following such an announcement is expected to be relatively minor, not the least because it has been well flagged and fully priced into markets in advance. By global standards, Australia’s financial stability and metrics still compare favourably and we will remain one of a select few of very highly rated (AA or higher) sovereigns available.  We also offer good economic diversity, a liquid currency and interest rate derivatives market, both of which provide an additional level of support for ongoing foreign demand of Australian paper. As a result, we would not anticipate any significant ratings action based forced selling of Australian Government Bonds, meaning that pricing should not be materially impacted. 

Semi Government Bonds – Kris Bernie (Portfolio Manager)

Relativities in the ratings in the Semi Government bond space will be affected by any downgrade of the Sovereign rating. This reflects that it is very difficult for a State Government to be rated higher than the Sovereign, so any AAA rated State would in all likelihood be downgraded to AA+ by S&P if Australia was downgraded by one notch. However, the lower rated States would not be similarly impacted, as they would not be rated above the Sovereign. This would see the ratings of NSW, Victoria and ACT debt lowered to AA+, hence equalling the rating currently assigned by S&P to Queensland and Western Australia. The compression in relative ratings would likely place narrowing pressure between the bond yields of the currently AAA rated and non-AAA rated States. However, the differential is unlikely to approach zero, as ratings are not the only driver of relative Semi Government bond spreads. In particular, the larger issuance programs of the currently AA+ rated State funding authorities is likely to limit how far the relative spreads will compress. While there is a chance of an initial reaction in AAA rated States on the announcement of a sovereign downgrade, the ongoing impact is therefore expected to be minor to both the overall and relative spreads in the Semi Government bond space.

SSAs (Sovereigns, Supras and Agencies) – John Barrasso (Portfolio Manager)

When considering the impact an Australian sovereign downgrade would have on AUD denominated SSA’s we need to look at the expected change in three key areas:

• Underlying Issuer’s Credit
• Investor Demand
• Relativities

Underlying Issuer’s Credit (Neutral Impact) - Of the 5 major issuers in the AUD SSA market (EIB, KFW, IADB, IFC & IBRD) only IFC and IBRD receive capital contributions from Australia.  At less than 1.5% of total contributions, a 1 notch downgrade would have little impact on IFC and IBRD and no impact on the remaining SSA names. Investor Demand (Positive Impact) - With a downgrade of Australian Sovereign debt, the already small universe of AAA rated bonds will get even smaller.  Certain Central Banks, Sovereign Funds and Asset Managers have restrictive investment guidelines regarding credit ratings on assets.  With the downgrade of ACGB’s and AAA Semi’s, there may be some forced reallocation, which should see AAA SSA’s be the clear beneficiary. Relativities (Positive Impact) – When considering the relativities to other AUD based fixed income products, SSA’s should be a clear standout. There is a small universe of liquid AUD Fixed income products which include ACGB’s, Semi-Government, Bank credit and SSA’s. All but SSA’s will be negatively impacted by a downgrade.  For those Treasuries and Asset Managers that look at relativities between SSA’s to the above downgraded bonds, it will be a compelling trade. As is the case in many market events that are “expected”, I would look for price action to reflect my views before the actual downgrade occurs.

Australian / US Yield Spread - Darja Milosevic (Portfolio Manager)

In theory, the announcement of an issuer downgrade in isolation would lead to higher yields being demanded by investors due to an assessed worsening in credit quality. That is if the downgrade was not anticipated and already priced in. Therefore in theory, an Australian sovereign downgrade would lead to higher yields on CGS relative to other sovereigns (wider AU-US spread) had it not been flagged and expected well ahead of time. But this has been a topic of discussion for some time now, and should therefore not come as a surprise. Importantly, a one notch downgrade would still leave Australia as one of the highest rated sovereigns globally, would not compromise the ability of most mandates to hold its bonds, and would not on its own trigger a widening in the AU-US spread. However, the sovereign downgrade is likely to be accompanied by bank downgrades (potentially a further notch if the standalone credit strength is also downgraded), leading to wider bank spreads. I can see two different scenarios playing out in this case. Selling banks and switching to CGS would potentially lead to a modestly narrower AU-US spread.  However, this could be short lived if adjusted spreads are seen as offering good value as then the net impact on sovereign spreads would be neutral. Alternatively, if bank widening lead to general selling of Australian bonds, the AU-US spread could widen. Overall, the expectation is for an unchanged to a slightly wider spread to the US.

Domestic Credit – Alan Ng (Credit Analyst)

Any sovereign downgrade has a flow-on effect to other entities in the same country. Multiple rating downgrades typically follow due to sovereign links (either ownership or support), or the sovereign rating cap. In this regard, Australia is no exception. A one-notch downgrade of Australia’s AAA rating would likely lead to similar ratings actions on the AAA-rated semis, a couple of government-linked entities (Export Finance & Insurance Corp which is wholly government owned and guaranteed, and Airservices Australia which is 100% owned) and the Australian major banks. The rating outlooks on the major banks were changed from stable to negative by S&P in July 2016, in line with the action on Australia’s local currency sovereign rating to reflect a potential reduction in the government’s capacity to support systemically-important financial institutions if required. Ongoing build-up of economic imbalances and rising private sector debt also prompted Moody’s to change the rating outlooks on the major banks to negative. S&P subsequently broadened the negative outlook change to 25 other financial institutions in Australia for similar reasons. S&P’s ratings for CBA, NAB, ANZ and Westpac incorporates their standalone credit strength, the ability and willingness of the government to provide support, as well as the quality of that support. As S&P reassess its opinion on the likelihood of government support for systemically important financial institutions, a rating downgrade of the banks may potentially occur independently of any action on the sovereign. We think it matters whether a future bank rating downgrade results from a sovereign downgrade, or a downgrade of its standalone credit strength. The latter is more likely to have a material spread impact in our opinion.

Inflation – Magda Kinal (Portfolio Manager)

Australian breakeven inflation is defined as a spread between the sovereign government nominal bond and the maturity equivalent inflation linked bond (ILBs). Hence the implications for an Australian sovereign downgrade described in the sovereign bond section are removed leaving inflation expectations as the residual factor exposed. Typically a sovereign downgrade results in currency depreciation as investors’ confidence in investing in the country’s assets declines. Expectations of lower currency would boost the outlook for near term inflation and have a widening impact on breakeven inflation. The other potential implication is related to the foreign ownership of Australian Government bonds. In the event of a sovereign rating downgrade there is a possibility of offshore investors being required to reduce their allocations to Australian Government bonds based on their rating constraints in their mandates. Foreign investors currently hold around 30-35% of the inflation linked government securities on issue compared with 55% ownership of nominal bonds. That would possibly imply less selling of ILBs. This scenario would have a slightly widening impact on Australian breakevens. Saying that, I believe the forced selling scenario would be at the margin for a one notch downgrade from AAA to AA+. Overall, the impact for Australian inflation would be expected to result in neutral to wider BEIs.