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Credit is a form of trust in the financial world. The functioning of the economy relies on the belief that borrowers will fulfill their obligations by paying interest on loans and returning the principal amount on time. In this context, credit ratings play a crucial role, especially during times of financial stress, such as the present.
The significance of credit ratings was recently highlighted by rating agency Fitch, which downgraded the credit rating of the US federal government. While rating agencies faced criticism for their flawed validation of mortgage-backed securities leading to the 2008-2009 financial crisis, they still possess the audacity to criticize powerful governments for their poor economic management.
Fitch downgraded the US sovereign debt rating from AAA (the highest) to AA+. This downgrade indicates Fitch’s belief that the US is less capable of repaying its debts compared to countries like Germany and Australia, which still maintain AAA ratings. Fitch points out that the US government has borrowed excessively and spent irresponsibly, with an expected debt-to-GDP ratio of 113%, two and a half times higher than that of a median AAA-rated country.
Fitch, Standard and Poor’s, and Moody’s are the three most prominent credit rating agencies worldwide. Moody’s still rates the US as AAA, while S&P downgraded it in 2011 due to political brinkmanship over the US debt ceiling, a problem that persists to this day.
Should US retail investors holding Treasury bonds be worried about Fitch aligning with S&P’s downgrade? Probably not. Yields on Treasury bonds have been rising alongside interest rates. The yield on 10-year Treasury bonds is currently close to a 16-year high of slightly over 4.3%.
The current challenging financial conditions offer credit rating agencies an opportunity to regain public trust. They need to demonstrate more accurate debt ratings, distancing themselves from the flaws exposed during the financial crisis when they accommodated banks that paid them fees and labeled risky securitizations as “investment grade.”
Many large investors only invest in bonds with investment-grade ratings, as lower-rated securities are considered high-yield or “junk.” These riskier investments are usually left to specialists. Ratings of BB+ from Fitch and S&P, and Ba1 from Moody’s define the border of the financial junkyard. As ratings drop to C and D, the risk of default increases accordingly.
Developing nations with poor borrowing records often fall within these lower-rated categories. In developed economies, high-yield credits typically consist of riskier companies. Investors in high-yield credits expect higher returns to compensate for the increased risk. Currently, US corporate junk bonds yield just over 8%, approximately double the yield of equivalent Treasury bonds.
Another parallel with 2007 is the focus on property. Falling house prices in Europe have become concerning. Swedish property company SBB, which borrowed heavily during a local property boom, was recently downgraded to B- by Fitch.
Commercial real estate is experiencing even more significant challenges. US flexible offices group WeWork was recently downgraded to CC, signaling a possible imminent default. Fitch has warned of potential knock-on effects on the US banking sector, including credit downgrades due to loan losses. If a property crisis were to emerge, credit analysts can at least claim they had warned about it.
BHP steels itself for Chinese economic downturn
Mining stocks used to be seen as indicators of metal prices, but their price sensitivity has decreased as dividends have taken center stage. According to Bloomberg data, total shareholder returns have relied more on dividends than share price gains since 2015.
At BHP, which heavily depends on iron ore and copper, the cash flow for its 9% dividend yield primarily comes from China. Therefore, the country’s economic problems pose a risk to this payout.
China has repeatedly lowered interest rates in an effort to stimulate its economy, yet the renminbi has reached a nearly 15-year low against the US dollar. Country Garden, China’s largest privately-owned residential developer, has missed interest payments on its international debt. A Chinese analyst warns that the country may be approaching a “Lehman moment” where property market issues could spread across China.
BHP CEO Mike Henry is trying to remain optimistic about the situation, although the company’s full-year results reveal a significant decline in profits. Ebitda dropped by 31%, primarily due to iron ore and copper. Free cash flow shrank from $25.2 billion to $5.6 billion. Even with a dividend reduction, BHP’s declared payout of $8.6 billion exceeded its free cash flow.
However, Henry is correct in stating that the impact of China on BHP’s performance this year is not yet clear-cut. Barclays points out that ebitda for iron and copper increased in the second half of the year compared to the first half. Chinese steel exports have been on the rise, as well as crude steel production. There do not appear to be any significant difficulties in the domestic steel demand resulting from property market problems.
Furthermore, copper prices have dipped since January, but key industrial demand indicators have not yet signaled any warnings. Morgan Stanley states that Chinese property completions, electricity grid spending, and air conditioner output in the first half of the year are higher compared to the same period in 2019.
Nevertheless, BHP’s generous dividend payments cannot be sustained indefinitely, especially now that Henry has increased the company’s annual investment target by 10% to $11 billion. If Chinese metals demand falters, BHP’s dividend will also be affected.
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