Ratings agency Standard and Poor's went on a bit of a downgrading rampage yesterday, taking the market by surprise by slicing some oil-exporting sovereign credit ratings by as much as two notches. The majority of the rating decisions were based on the agency’s revisions to oil price assumptions; of Brent crude averaging $40pb this year and $50pb by 2018. Affected countries include Brazil, Kazakhstan, Oman and Saudi Arabia, amongst others.
Of the countries within which we invest, Saudi Arabia’s rating was revised to A- (rated Aa3 by Moody’s and AA by Fitch), and Oman was cut to BBB- (rated A1 by Moody’s). Aware that oil has had an impact on these countries’ balance sheets, we were not surprised by the agency's decision to downgrade. The CDS on these countries more than prices in these downgrades; for example Saudi Arabia’s 5-yr CDS is currently 185bps, ~100bps wider since September 2014; when oil prices began their descent.
Our exposure to these two nations is via two positions in Saudi’s dominant utility company (SECO) and a holding in Lamar Funding; the state-owned funding vehicle for the country’s electricity transmission network. Rated A1/A+/AA-, the SECO 5.06% 2043 and 5.5% 2044 issues are backed by the sovereign’s ratings; as the Gulf’s largest utility firm is 81% owned by the Saudi government. These bonds continue to offer some of the most attractive risk-adjusted expected returns of ~30% (fair value), with a yield ~6% and offer plenty of cushion; roughly 5 notches, against unexpected events. The Lamar Funding 3.958% 2025 issue, rated A3/BBB/BBB+, yields an attractive 5.7% with an expected return over 15.5% and trades at 3.5 notches cheap; more than compensating for any downgrades. We are not look to change our positioning in any of these holdings for the time being.
The GCC basket case, Bahrain, was downgraded two notches to junk (BB); Standard and Poor’s cited the “acute” pressure on revenues since oil prices began to slide in 2014. The rating firm stated that it has projected the oil rut to be especially hard on Bahrain, despite the “material and imminent” support from Saudi Arabia, but added that the outlook is stable. This is the first time a Gulf state has been rated below investment grade since 1999. As previous holders of Bahrain, we closed our positions in the sovereign last year, way ahead of the one notch downgrade in November, noting the downward pressure from falling oil prices. We believed we were not being compensated enough for the risk we would be taking had we continued to hold the issues. Regular readers will also recall a daily written at the end of November 2015 which highlighted our concerns of a further rating downgrade to junk.
Elsewhere, Brazil's “political and economic challenges” remain of some concern to Standard and Poor’s, which now expects a “more prolonged adjustment process -- a slower correction in fiscal policy as well as another year of steep correction.” The agency, which had already cut Brazil’s rating to junk back in September last year, further cut its rating by one notch to BB. We have never held any Brazilian debt within our portfolios, whether sovereign or corporate, as our fundamental analysis of Brazil alongside our macro views have made us reluctant to add exposure to the country, despite the offering of high yields of over 6.8% on the benchmark USD 10-yr. Brazil 5-yr CDS is currently +481bps, ~320bps wider than September 2014 levels.