Signs of the times: From JP Morgan to Mood’s

It was in September 2015 that the global investment bank, JP Morgan decided to remove Nigeria from its emerging market bond index with effect from October 31 of the same year. Similarly, international credit rating agency, Moody’s Investor Services on Friday, April 29 announced a downgrade of Nigeria’s sovereign rating from Ba3 to B1. While both are not positive events for the country’s economy, it is important to first understand the meaning, and reasons for these actions and secondly their potential consequences on the economy.

What are bond indexes and credit ratings? As the question suggests, the answer is in two parts: what a bond index is and how they work and what sovereign credit ratings are and how they work.

Most investors in bonds (i.e. fixed-income securities with tenors of three years or more) use what is called a passive investment approach. Instead of selecting individual bonds across countries, sectors, industries and issuers, such investors simply select an index, or ‘super portfolio’ of bonds that closely reflects their desired risk exposure for geography, countries, sectors, industries etc and seeks to replicate the composition of that index in their own bond portfolio. To make matters simpler, there are information services that build such “model portfolios” and provide update information on the actual composition of the indexes to bond investors.

JP Morgan runs one of such information services. Its Global Bond Index-Emerging Markets (GBI-EM) of which Nigeria accounted for 1.5% of the index value as at the time of removal on October 31, 2015 has a total value of US$183 billion. Before an issuer’s bond is included in an index, the index manager checks to make sure the bond (and its issuer) pass a few tests. An important aspect of such tests is that the bond must be both investable and liquid. Investable means an investor is able to maintain a buy-and-hold position in the bond while liquid means that in the event that the investor decides to exit his/her position in the bond, he/she does not face a significant risk of loss due to lack of market interest. In addition to bonds, JP Morgan and other index managers maintain indexes on other asset classes such as equity, derivatives, real estate and commodities.

For foreign investors (who control the bulk of funds that track emerging market bond indexes), it’s also important that proceeds from the local currency sale of such bonds be easily convertible to the investor’s own currency without any significant loss or restrictions. Also, the bond is usually required to be within the threshold of a specified grade. If the bond/or issuer begins to show signs of failing the tests on the basis of which it was included in an index, the service provider or index manager makes a formal announcement that effective a specified future date, the bond will be excluded from the index.

Subsequently, institutions who hold such bonds initiate plans to sell off or exit the bond so as to ensure their portfolio continues to reflect the new composition of the index which they consider to be a closer match for their investment strategy given their risk tolerance. What this also means is that demand for the country’s bonds from such investors will drop. In other words, the propensity of foreigners to supply capital to the issuer or country through the bond market drops. As a result, borrowing costs for the country or issuer will rise because the investors who choose to stay will require higher yields for taking what they consider to be a higher level of risk.

Now we turn to the issue of credit ratings. Over the decades, investor services providers have created a fairly consistent (though not uniform) system of categorizing the amount of credit risk that a particular debt or bond instrument represents. The basic considerations here are the fundamental risk factors of the issuer in the context of its operating environment. The US government historically has had the highest rating of triple A (AAA) while other strong countries and corporations have AA, A or BBB. Any rating below these first 4 categories is considered by Standard & Poor’s to be below investment grade. Moody’s, Fitch and other rating agencies have similar grading systems. A standing rule is that the credit rating of a corporate issuer cannot be higher than that of the sovereign within who territory it operates. So when Nigeria’s bonds get a downgrade, all corporate issuers with the same credit rating as the country’s also take a hit.

Last week’s downgrade of Nigeria’s sovereign credit rating by Moody’s is based on three factors: Increased external vulnerability brought about by the prospect of lower-for-longer oil prices; execution risk in the transition to a less oil-dependent federal budget, and the implications for the government’s balance sheet should it not achieve its aims; an elevated interest burden over the next two years while the government grows its non-oil tax receipts.

In a way that is similar to the effects of removal from a major bond market index, when a country’s credit rating is downgraded, many institutional investors who hold the nation’s debt instruments may be forced to sell-off or reduce their holdings. This follows the fact that the current grade of the country’s debt no longer meets the investment policy requirements of such investors. Again, investors that choose to stay or enter the market for such bonds will require higher returns for the perceived higher risk.

While the actions by both JP Morgan and Moody’s may be blamed on events in the external environment, it is also a fact that these external events merely reveal the vulnerabilities of Nigeria’s domestic economy. Hence it remains vital that the country’s monetary and fiscal authorities formulate and execute effective responses to both new and age-long issues that constrain the country’s economic performance.

David Adeoye