Spreads Reflect Markets’ Assessment before Rating Changes
Spreads Diverge Ahead of Ratings Changes
Although Hungary and Turkey credit spreads were at similar levels and generally moved together through 2014, these spreads began to diverge in early 2015. As Turkey’s credit spreads widened, Hungary’s credit spreads generally tightened. These spread changes occurred well before the countries’ changes in investment grade status, indicating that the market’s assessment of credit risk may have anticipated these rating actions.
For an investor in U.S. dollar-denominated Hungarian sovereign bonds, this translated into an 8% cumulative return attributable to credit spreads from 12/31/2014 to 9/30/2016. During the same period, Turkish bond investors lost 1% based on credit spreads. Although isolating the impact that credit spreads have on returns helps to understand the market’s view of a country’s credit risk, total returns are also driven by other factors such as interest rates. Overall for the period, Hungarian bonds posted total returns of 14% and Turkish bonds returned 6% (as measured by country sub-indices of the J.P. Morgan EMBI Global Index).
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Market Realist – Rating downgrades are a validation of what the market already thought
As depicted in the chart above, Turkey began this year as one of the safest in terms of emerging market (EMLC) (HYEM) credit risks, as depicted by Deutsche Bank’s Credit Default Swap (or CDS) implied default probabilities. The political turmoil, which started at the end of May, brought about the sudden withdrawal of foreign investors and weakened the lira against the dollar. Markets also started reassessing Turkey before July’s failed coup due to its high default probability. According to Bloomberg’s sovereign risk model, the probability was greater than about 80% of nations. The subsequent events increased the country’s risk premium, which went from bad to worse. Now, towards the end of 2016, analysts see the country as having a higher risk of default.