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S&P's new rating methodology for public sector funders unlikely to result in cut to LGFA, investors say

Wednesday 4th July 2018

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New Zealand's Local Government Funding Agency, which sells bonds on behalf of local authorities, isn't expected to lose its sovereign-equalling credit rating as a result of Standard & Poor's new rating methodology for public sector funders, investors say.

In May, S&P placed ratings on 10 non-US public-sector funding agencies under what it calls "under criteria observation" (UCO), including the LGFA. The ratings agency developed the new methodology in an attempt to better reflect the characteristics of such bodies, which it said were "specialised not-for-profit institutions established to secure and provide cost-efficient funding to public sector entities in their domicile country or region."

As at June 18, there were $8.1 billion of LGFA bonds on issue, making it second only to the Crown among New Zealand issuers. Both have an AA+ credit rating and both have an April 2023 bond on issue paying a coupon of 5.5 percent but the government bond is yielding 2.15 percent and the LGFA 2023 bond was recently at a yield of 2.89 percent. The gap, or yield spread, between the two bonds has widened in recent months to sit at about 70 basis points amid speculation the LGFA could see its credit rating cut a notch.

"Some people are a bit concerned it might be downgraded. We don't share that view," said Mark Brown, fixed income portfolio manager at Harbour Asset Management.

Helping explain a widening yield spread between LGFA debt and government bonds was that it echoed a global widening of credit spreads, which "have moved a lot more than in New Zealand and there's a risk we move further from here," he said. Added to that has been a run of corporate bond sales which may have seen some institutional investors sell bonds including LGFA's to free up cash.

The yield on a bond goes up as the price falls. Brown said local authorities "are never viewed as being as strong a credit as the government and theoretically, people apply a liquidity premium to the LGFA.

There are about $9.2 billion of government April 2023 bonds on issue out of total government bonds in the market of $74 billion. The LGFA has $1.5 billion of its own April 2023 bonds on issue out of its $8.1 billion total.

In its latest Rates Strategist report, Bank of New Zealand said the LGFA's 'mid-curve' bonds such as the one maturing in 2023 are cheap relative to government bonds and have also under-performed swaps over the past fortnight. BNZ interest rate strategist Nick Smyth singled out the LGFA 2023 bond (along with the April 2025 bond) as a standout, being "notably cheap to us on a variety of metrics".

His only hesitation in recommending trades that would benefit from the bonds' relative value is the potential risk of a ratings downgrade to AA by S&P.

"Although it's not our base case, in the event of a ratings downgrade, we see the potential for up to 10 basis points of spread widening in the LGFA 2023s (which would see it trade similarly to AA-rated Auckland Council’s recent 2023 issue)," Smyth wrote in the report.

"We remain long-term positive on LGFA given the attractive yield pick-up to the NZGB curve and very modest net issuance profile for this year," he said.

Following the weak NZIER Quarterly Survey of Business Opinion (QSBO) yesterday, economists at Bank of New Zealand said it was "more evidence" that the New Zealand economy was entering a pseudo-stagflation phase, where "growth indicators continue to come under downward pressure while inflation pressures build further." The report showed similar results to the monthly ANZ Business Outlook survey that Kiwi businesses have become less upbeat about profits and more concerned about rising costs.

Harbour Asset's Brown said stagflation was "a macro label to characterise economic performance in the 1970s. But it's the same thing in a directional sense."

He said "inflation looks to be higher despite economic growth that's not so good. There's weakness in business confidence. Some of that you can put down to the fact that costs are rising" such as the fuel tax and prospect of rising wages. A stagflation-like effect "is upsetting for equity markets and bond spreads."


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