The Daily Update - China downgraded, but still offers value

This morning Moody’s downgraded China’s rating one notch from Aa3 to A1. This is still a high investment grade rating with Moody’s affirming, in their report, that China still has ‘very high’ ‘economic strength’ and ‘fiscal strength’ which in turn give the country a ‘high economic resiliency’ and ‘government financial strength’. The downgrade puts China’s rating in-line with Japan’s and aligns Moody’s assessment with Fitch’s (where China has never exceeded the current A+ level). Standard and Poor’s currently rate China AA-, with a negative outlook. The move was of little surprise to markets; having been on negative review for some time now. As such it was mostly priced in already and market moves on Chinese sovereign and corporate paper, and the renminbi have been limited since the announcement.

Moody’s ongoing commentary on China had continued to stipulate that accelerated reforms were required to prevent the downgrade; the present pace of the government’s reforms are sub-optimal from a long term growth perspective. As such, this downgrade reflects this slightly weaker long term outlook on the country’s credit position and ‘Moody’s expectation that China’s financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows’. The still high A1 rating is substantiated upon China’s fast economic growth, high government savings, government control of the financial system and financial flows, and its moderate level of low cost government debt.

It’s important to highlight that even with this downgrade, the USD denominated Chinese bonds we hold continue to offer attractive value: with a much higher spreads relative to what is typically available in the Aa3/A1 space. For instance, currently our China positions are on average around 3.7 credit notches cheap. This means that such high spreads/yields are more typical of Baa1 rated bonds. Forming a diverse portfolio that focuses on the best of these relatively cheap bonds both provides ongoing additional returns (while maintaining a high single A weighted average rating) and acts as a cushion in the spread to protect against any deterioration or negative sentiment.

Moody’s assessment of China’s long term economic strength is not too dissimilar from our own, but while value opportunities persist in Chinese quasi-sovereigns and strong corporate credits we believe we are being more than adequately compensated commensurate to the risk, and have the space to reevaluate should anything change significantly.

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