For people who know us well, the observation that ‘credit ratings don’t tell you everything’ will come as no surprise. We certainly value the input provided by rating agencies but there is something missing.
As investors, we are concerned with assessing risk and the rating agencies’ focus on evaluating the probability of default is undoubtedly an important factor. However, from my perspective this is too narrow; there is a bit of the jigsaw that is missing. And this creates one of the key inefficiencies of credit markets.
Let’s take Tesco as an example. All three major rating agencies give Tesco unsecured bonds a BBB- rating (or equivalent). Not a great investment grade rating, but reflective of leverage and business challenges. This is the same rating as Tesco Property bonds. On the face of it this is reasonable: same underlying risk, same rating. But, in reality this is nonsense. Whilst the probability of Tesco defaulting may be the same for both types of bonds, the outcome for investors will not be the same. It is this difference in outcome that is not captured by rating agencies. So, what is the disparity? In essence, both types of bonds are dependent upon the health of Tesco plc but secured bonds have access to a ring-fenced pool of assets in the event of default. Unsecured bonds have no such collateral. Of course, in the event of default, the retail units and distribution centres that form of collateral will be of reduced value, but you will still be in a better position than having none. This difference in risk profile is not captured in ratings. More perversely, investors achieve a higher credit spread on the secured bonds. Don’t tell me that markets are efficient.
Ratings and the US
What are we to make of the Fitch downgrade of US government debt, losing its AAA status? Looking at the Fitch assessment it is hard to disagree with observations made. The governance process for overseeing US debt is a shambles – my words, not theirs. The near-annual debt ceiling circus, with the ‘will they / won’t they default’ could in itself merit a lower credit rating – although I don’t think investors have contemplated non-payment on government bonds even if other obligations were missed. This is only one part of the Fitch analysis. The growth in government debt and the costs associated with Social Security and Medicare imply that funding pressures are set to grow and that debt repayments will eat up a growing percentage of government revenue.
Global bond markets were initially unnerved by this downgrade with 10-year US treasury yields rising to 4.2%, approaching the highs of last year and accompanied by a steepening of the yield curve. On the face of it, a pretty simple message: tighter financial conditions and further headwinds to global growth as a result of the downgrade. Last Friday’s jobs data changed the script with the July report showing a loss of momentum. Coupled with signs of improvement in unit labour costs, this was enough to reverse the rise in yields. So, by the close on Friday, 10-year rates were hovering just above 4%.
UK peak rates to be lower?
In the UK, attention was centred on the latest Bank of England rate decision. In the end, they delivered a 25 basis points (bps) rate hike, taking the level to 5.25%. This was a split vote with two members voting for 50bps and another wanting to keep rates unchanged. Messaging remained the same: “If there were to be evidence of more persistent pressures, then further tightening in monetary policy would be required.” We did get new inflation estimates with mean Consumer Price Index forecasts of 2.0% and 1.9% at the two-year and three-year horizon respectively. The take is that rates will not reach the levels priced into markets in early July, when expectations were around 6.5%, but that these may stay high for a while. The peak is now priced at around 5.75%, expected to be around the end of this year and stay at these levels through 2024. It is a difficult balancing act. As the unemployment rate remains low and business surveys look consistent with private sector growth, domestically generated inflation is a concern. Conversely, there is emerging evidence of the effects of past monetary tightening coming through. From April to June the number of vacancies fell by 7.6% with decreases in 13 of the 18 industry sectors, continuing a trend seen through 2022.
Sterling bond markets reflected the global trends. Accompanying the sell-off in US bonds, 10-year UK rates approached 4.5%, before rallying to end the week below 4.4%. Real yields mirrored these moves with the 30-year above 1.2% at one point, a far cry from the -2.5% seen in late 2021. Credit markets remained relatively becalmed with the summer lull now in full swing. Issuance activity remains low and secondary market interest is biased towards the buy side. AT1 subordinated financial bonds continued to see further calls, helping financials to outperform.
Finally, remember that credit ratings don’t tell you everything. Fitch may have downgraded but the US remains the world’s dominant nation. In my view, despite recent events, it remains a vibrant democracy, with an entrepreneurial flair lacking in other developed countries, and a great ability to adapt to changing circumstances.
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