Credit ratings: time for downgrades for lenders, property and the US
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Credit is trust given financial form. Economic life depends on creditors believing that borrowers will pay interest on loans and return principal when it is due. Credit ratings are essential to this, particularly when financial stress is high, as it is now.
Their key role was highlighted by rating agency Fitch, when it downgraded the US federal government this month.
Critics rightly lambasted rating agencies for the flawed validation of mortgage-backed securities that triggered the financial crisis of 2008-9. But the agencies at least have the nerve to tell powerful governments their economic management is poor.
Fitch busted the US’s sovereign debt rating down from AAA, the highest, by one notch to AA+. Fitch’s analysts thus signalled their belief that the US is less able to repay its debts than Germany, Australia or some other countries still with AAA ratings.
Successive US governments have simply borrowed too much money and spent too irresponsibly. Fitch notes the expected debt-to-GDP ratio of 113 per cent this year is two and a half times that of a median AAA-rated country.
Fitch, Standard and Poor’s and Moody’s are the world’s three most prominent agencies engaged in rating wholesale debt. Moody’s still rates the US as AAA. S&P downgraded it more than a decade ago in 2011. In part this was a response to political brinkmanship over the US debt ceiling. That problem is as alive today as it was then.
Many US retail investors hold Treasury bonds, or their short-term equivalents, Treasury bills. Should they be worried by Fitch falling in line with S&P?
Probably not. Yields rose in response to the announcement, which means prices had fallen. But they have been marching higher with interest rates anyway. Yields on 10-year Treasury bonds are close to 16-year highs at just over 4.3 per cent.
Today’s tougher financial conditions give credit agencies a chance to redeem themselves in public opinion. They just need to show they rate debt more accurately than during the financial crisis. Back then, they cosied up to the banks that paid their fees and labelled dodgy securitisations as “investment grade”.
Many big investors will only buy bonds with that status. Securities rated as “subinvestment grade” are defined as “high-yield” or less politely as “junk”. Higher risks make this a market for specialists.
The perimeter of the financial junkyard is defined by a rating of BB+ from Fitch and S&P, and Ba1 from Moody’s. As ratings drop to C and D, the risk of default rises accordingly
Developing nations with bad borrowing records may fall into these buckets. In developed economies, high-yield credits tend to be riskier companies.
Higher returns compensate investors for this risk. US corporate junk bonds currently yield just over 8 per cent, about double the equivalent Treasury bonds.
High interest rates are not the only parallel with 2007. Property is also back in the spotlight. In Europe, falling house prices are hurting. One of the casualties is Swedish property company SBB, which borrowed heavily during a local boom. Fitch downgraded the company to B- this week.
Commercial real estate is in even worse shape. US flexible offices group WeWork was recently downgraded to CC, one notch above a C rating. A C signals a default may be imminent.
Fitch has warned of knock-on effects to the US banking sector, including credit downgrades from loan losses. If a property crisis does emerge this time, credit analysts can at least say they told us so.
BHP steels itself for Chinese economic downturn
Mining stocks were once regarded as a proxy for metal prices. Such price sensitivity has dwindled as dividends have taken centre stage. Since 2015, total shareholder returns have depended more on dividends than share price gains, according to Bloomberg data.
At iron ore and copper dependent BHP, the cash flow for paying its 9 per cent dividend yield primarily comes from China. The country’s economic problems put this payout at risk.
China has repeatedly cut interest rates in an attempt to boost its economy. Still, the renminbi has sagged to a near 15-year low against the US dollar. The country’s largest privately owned residential developer, Country Garden, has missed interest payments on international debt. One Chinese analyst warns that the country is approaching a “Lehman moment” in which problems in the property market could spread across China.
BHP chief executive Mike Henry is attempting to put a positive spin on this situation, though full-year results show how far the company’s profits fell. Annual ebitda dropped by 31 per cent, mostly due to iron ore and copper. Free cash flow contracted from $25.2bn to $5.6bn. Even with a dividend reduction, BHP’s $8.6bn declared payout exceeded free cash flow.
However, Henry is right to say that China’s impact on BHP this year is not yet clear cut. Ebitda for iron and copper rose in the second half of the year when compared with the first half, as Barclays points out. Chinese steel exports have increased over the past two years, as has crude steel production. Residential property market problems do not yet seem to be hitting domestic steel demand.
More good news: copper prices have dipped since January, but key industrial demand indicators have yet to flash a warning. Chinese property completions in the first six months of the year are higher than the first half of 2019, says Morgan Stanley. The same comparison holds for electricity grid spending and air conditioner output.
Even so, BHP’s dividend largesse cannot hold out forever. Particularly now that Henry has upped BHP’s annual investment target by a tenth to $11bn. If Chinese metals demand falters, so will BHP’s dividend.
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