Head of Credit Research & Strategy
Director, Research & Strategy
Australia’s hold on its AAA credit rating is under pressure after Standard & Poor’s (S&P) moved the country’s sovereign rating from ‘stable outlook’ to ‘negative outlook’. There have long been fears the country’s persistent budget deficits would drive a downgrade, but for S&P the recent Federal election tipped the scales—the rating agency expressed grave doubts about the re-elected government’s ability to legislate sufficient savings or revenue measures.
Australia now has a 1 in 3 chance of being downgraded within the next 2 years, but in our view a downgrade would have little material impact on the price of government bonds, or its borrowing costs. It would instead be the country’s major banks that would be impacted.
Westpac, CBA, NAB and ANZ have already seen their S&P ratings shift from AA- stable, to AA- negative as they risk losing one of their two notches of rating uplift that stems from the government’s support.
The move was widely anticipated, major bank credit spreads only modestly underperformed in the days following the negative outlook shift. But the widening will continue if they’re eventually downgraded.
Since the announcement both the Australian dollar and the big banks’ share prices have strengthened, and the government’s ten-year bond yield has remained at all-time lows.
In a world of zero-bound interest rates, Australian bonds currently stand-out with their relatively high yields. As was discussed in the Global Liquid Strategy team’s latest Red Paper, Navigating negative interest rates and liquidity challenges, the adage ‘there’s no place like home’ has rarely rung more true.
However a sovereign downgrade would likely see S&P re-rating the senior debt of the banks from their current AA- level, down to A+.
The major banks’ senior unsecured credit spreads could widen another 10bps in the event of an S&P downgrade. Based on peers (Figure 1), this would increase to as much as 15 to 20bps, should the other two rating agencies take similar action. However, we believe a re-rating by Fitch and Moody’s, to the ‘A’ category, is less likely, irrespective of potential pressure on the sovereign rating.
We suspect the major banks will choose to pass this added cost on to borrowers in the form of lending rate increases. But if they don’t go down that road, the downgrade would still be manageable. Based on an annual wholesale funding task of approximately $100 billion in total, an increase in their credit spreads would see their interest bill increase by up to $200 million initially, which is modest compared to their $45 billion in aggregate pre-provision earnings.
But it may not come to that; there are a number of offsetting factors that could come into play. Firstly, the global forces of weak inflation and GDP which will keep borrowing costs low.
Similarly, A+ is still a relatively strong rating so we believe investors will continue to have demand for issuance from the majors. Critically, the rating threat doesn’t reflect the credit fundamentals of the majors which we believe remain strong – their capitalisation is at an all-time high, earnings are robust and asset quality is good, despite the likelihood of normalisation in the years ahead.
There’s also the chance the banks’ standalone credit ratings may actually see an improvement on the back of increased regulatory capital requirements. But they would have to raise a lot of capital.
S&P have stated each bank would need to raise $7-8 billion of common equity. To put this in perspective, consider that the banks raised a total of around $19 billion in common equity in 2015. So pulling in a further $30 billion across the Big Four over the next 1 to 2 years is a big ask— even though regulatory forces will necessitate further capital build.
The re-elected Liberal-National Coalition faces a tough balancing act. Austere policies that are focussed only on reducing the budget deficit would crimp growth, putting further pressure on consumers and businesses. Interest rate cuts by the RBA will likely then follow; which would see a further over-heating of real asset prices, as well as hurting savers.
A polarised parliament means the government will find it increasingly difficult to implement its economic policies. A representative of Moody’s says “…a more splintered outcome in the Senate is credit negative for the sovereign”. The agency didn’t go as far as S&P’s move to giving Australia a negative outlook, saying it will wait and see.
While the narrow win by the Coalition will make it harder to pass legislation, it will also offer the Australian banks a modicum of breathing space.
The Labor Party’s pre-election policy proposals had included restrictions on the use of negative gearing, as well as the potential for a royal commission into the banking industry. In fact the Liberal Party is the only group in parliament opposed to a Royal Commission.
With the likelihood of this now diminished, the banks have greater scope to make further out-of-cycle hikes to mortgage rates. This move is never going to be popular; no-one likes to see their loan repayments rising. But should a sovereign downgrade put pressure on credit spreads, and with low rates pinching margins, the banks will be looking to reprice assets.
The potential for a credit rating downgrade of the major banks does exist. This will put upward pressure on their senior unsecured credit spreads, although the size of the move, and the associated earnings impact, will be reasonably muted. Earnings changes in particular should be subdued if the banks elect to pass on the higher funding costs in the form of lending rate increases.
But with the credit profiles of the four majors remaining strong, attractive opportunities may present. We’re keeping subordinated debt and Residential Mortgage Backed Securities (RMBS) in our sights.
Our view is that subordinated debt ratings of the majors, which don’t include uplift for government support, won’t be impacted. Should major bank subordinated debt spreads widen significantly following a downgrade of the senior rating, we would see it as a potential buying opportunity.
Similarly, the ratings of RMBS issued by the major banks will not be impacted. The credit quality of these transactions is more closely driven by their in-built credit enhancement and the quality of the underlying mortgages, rather than the ratings on the banks themselves. We believe AAA RMBS of the major banks remains attractive irrespective of the threat to their senior unsecured ratings.
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 Moody’s Investor’s Service, Government of Australia: Small Majority Will Challenge Ability to Pass Fiscal Measures, 13th July 2016. Accessed at; https://www.moodys.com/research/Government-of-Australia-Small-Majority-Will-Challenge-Ability-to-Pass-Issuer-Comment--PBC_1034709 (subscription only)