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David Fisher, Michael Story, Olivia A. Albrecht
Because the recent European Union (EU) ratings cuts by Standard & Poor’s were generally anticipated by investors, and were in most cases not as large as feared, the market reaction was relatively muted: some 10-year bonds rallied (Italy -22 basis points, Spain -7bps) while others sold off marginally (France +6 bps, Austria +6 bps, European Financial Stability Fund (EFSF) +10 bps) according to Bloomberg as of January 19. The notable exception was Portugal (10-year +200bps and 5-year +300bps) which is now rated below investment grade by all three agencies. Despite the tepid market response to the news, many investors are concerned about the potential impact of the downgrades on the eurozone crisis -- in particular, the implications for ratings on European banks and government guaranteed securities and for the composition of global indexes with exposure to downgraded sovereigns. Here, members of PIMCO’s global product management team answer some of the most common questions being asked by investors:
Q: Is this the end of the downgrades?A: We do not believe this is the end of the downgrades for eurozone sovereigns or European banks because most remain on negative watch by the agencies. And yet the real concern about S&P’s downgrades and further cuts by other agencies is the growing dispersion of ratings across the eurozone. Dispersion of ratings -- a reflection of the economic and financial bifurcation in the union -- is extremely problematic for the zone with a homogenized monetary policy yet heterogeneous fiscal positions. Moreover, by formalizing the credit differentiation within the eurozone, S&P’s move could accelerate the trend of intra-euro capital flight, where investors show a greater home bias propensity when faced with eurozone policy and credit quality uncertainty.
Q: Will European banks be downgraded?A: Sovereign downgrades will likely be another trigger for cuts in the ratings of European banks. Nearly all major eurozone banks are on negative watch. We believe the big Italian banks and Spanish banks are likely to see at least a one-notch cut with most major French banks also getting a one-notch downgrade. Concerns about market access are less relevant in an environment where most banks are already reliant on the ECB for their financing, but it should be noted that these downgrades may prolong banks’ dependence on the central bank and delay their return to market funding.
Source: S&P, Fitch, Moody's as of 19 January 2012
Q: Will banks be less inclined to hold certain eurozone sovereign debt because of the downgrades?A: Most eurozone government bonds owned by the eurozone banks carry a 0% risk weight as defined by prevailing regulatory capital rules. In theory, Italy’s downgrade to BBB+ by Standard & Poor’s should, therefore, have no impact on banks’ ability to hold BTPs (Italian government debt, or Buoni del Tesoro Polianuali). Despite theory, in practice these downgrades will likely put further pressure on foreign banks to reduce peripheral risk. But this de-risking is not new -- shedding of peripheral assets by banks has been a consistent feature of the past several months as banks have sought to shore up their capital ratios in line with European Banking Authority (EBA) stress tests and in an effort to demonstrate a reduction in peripheral risk exposures to international shareholders and creditors.
Q: How will government guaranteed securities fare in light of the downgrades?A: All so-called “government guaranteed securities” of those countries that were downgraded are now at risk of a ratings cut, including EFSF bonds, which were subsequently downgraded. Even those securities guaranteed by eurozone sovereigns not downgraded are also in the agencies’ crosshairs. More recently, 25 government-related entities of Austria, Belgium, France, Germany, Italy, Ireland, the Netherlands and Spain were downgraded and many more were placed on negative watch.
Q: How does the EFSF downgrade impact its role in resolving the eurozone crisis?A: With the rating of the EFSF dependent on the sovereign ratings that guarantee the fund, the subsequent downgrade of the EFSF was not surprising. At present, the EFSF has committed to fund a portion of the Portuguese and Irish bailouts, which should be manageable for it even with S&P’s AA+ rating.
The credit quality of the EFSF is inherently linked to that of its underlying guarantors’. Further eurozone sovereign downgrades or higher yields would therefore drive EFSF borrowing costs higher. However, the real challenge for the EFSF isn’t just its borrowing costs, but rather its ability to find buyers for its issuance fast enough in a crisis situation. If another country (aside from Ireland, Portugal and Greece) requires immediate support and the EFSFcannot raise sufficient funds in a timely fashion, then the ECB is the only institution that can provide this emergency liquidity. So while the EFSF is part of the eurozone resolution, the EFSF is not a silver bullet. It’s clear that the EFSF (in its current form) will not play the lead role in a eurozone resolution, but that was baked in before the downgrades.
Q: How will the downgrades impact the composition of global indexes?A: Each index provider utilizes a different methodology for calculating the ratings in their index based on the agency ratings — e.g., higher of (or average of) methodologies. In the recent S&P eurozone downgrades, the most relevant for benchmark compositions was Portugal -- downgraded to below investment grade by S&P, now consistent with Moody’s and Fitch. Portugal will be removed from the Citi suite of indexes at the end of January, affecting the February profile. The following table represents the decrease in a market capitalization of some of Citi’s flagship indexes as result of Portugal’s downgrade and removal. It should be noted, however, that subsets of these indexes could have a much larger impact.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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