The Philippines’ second upgrade to investment grade status in a month should have more impact on the local bond market than the country’s dollar bonds. But Indonesia’s downgrade is likely to have little impact on bonds and commentators still suggest an overweight position.
On May 2, Standard & Poor’s (S&P) upgraded the Philippines to ‘BBB-‘ stable, from ‘BB+’. The upgrade was due to a strengthening external profile, moderating inflation and the government’s declining reliance on foreign currency debt, according to Agost Benard, credit analyst at S&P.
The upgrade was widely expected by the market and the ratings agency was the second of the three major ratings agencies to upgrade the Philippines to investment grade in a month, after Fitch Ratings upgraded the sovereign to ‘BBB- stable’ from ‘BB+’ on March 27.
In a more surprising move, on May 2 S&P also downgraded the outlook on the Indonesian sovereign to ‘BB+ stable’ from ‘BB+ positive.’ S&P has been the only one of the three major ratings agencies to hold off from upgrading Indonesia to investment grade. This latest move is a clear statement from S&P that the Philippines has superseded Indonesia on the path to economic development.
“As far as S&P is concerned, the Philippines has overtaken Indonesia in achieving investment grade – Indonesia remains one notch below, even though it got to 'positive' much earlier – and it seems prospects for Indonesia making up ground are limited. We believe the two countries’ fortunes will continue to diverge,” said Euben Paracuelles, Southeast Asia economist at Nomura.
Positive development in the Philippines will be spurred by the fact that a second investment grade rating means the country should see a resumption in portfolio inflows, according to Vaninder Singh, Southeast Asia economist at RBS.
“The upgrade by S&P had been expected for some time. Despite this, increased inflows should still occur as the Philippines will now be added to indices that track investment grade assets. This will primarily benefit bonds, especially the domestic bonds,” he said.
“Portfolio outflows in March and April should now likely reverse. Upside for the dollar denominated bonds will, however, likely be limited as yields on these bonds are already comparable, if not lower, than those of other investment-grade countries.”
Dollar demand
Yields on the Philippine sovereign 10-year USD denominated bond were 2.181% at the time of going to press. Yields on the Indonesian 10-year USD sovereign bond were 2.905%. Thailand’s 10-year dollar-denominated sovereign bond was trading at 3.362% despite the country’s higher rating of ‘BBB+’.
In theory, the fact that the Philippines is now eligible for investment grade indices should mean that it will benefit from automatic benchmark inflows.
“Philippine bonds will become eligible for the Barclays Global Aggregate and Barclays US Aggregate indices. We estimate that incremental buying could be at least US$1.5 billion from passive benchmarked investors,” said Avanti Save, vice president of credit strategy at Barclays.
“[But] we think an index-related bid is unlikely to drive valuations tighter because Philippine sovereign bonds currently trade tighter than their peers already in investment grade indices. In our view, onshore demand for the bonds (on relevant investment grade status) will still overshadow any buying driven by index inclusion and will continue to be the key determinant of performance.”
Others agree: “Government bond yields could in theory fall sharply, as the bond market is opened up to a greater pool of potential investors. However, we are doubtful they will fall much further, if at all. For starters, funds with investment-grade mandates will not all shift just because of the upgrade,” said Gareth Leather, Asia economist at Capital Economics.
In addition, he said that other entities such as central banks might consider investing but will not base decisions solely on the sovereign ratings. Furthermore, on the whole, the market had already anticipated the shift.
“Moreover, there is a good chance that yields could increase later in the year if – as we think likely – the crisis in the euro-zone re-escalates, making investors cautious about buying risky assets. Previous periods of risk aversion have seen a spike in Philippines’ bond yields,” said Leather.
Overweight Indonesia
On the other hand, S&P’s decision to revise its outlook on Indonesia’s rating came as a surprise to the market, according to Save. However, it is unlikely to have a material impact on the country’s bonds.
“Although we view this is another negative for Indonesia, especially since the Philippines remains on a positive credit trajectory, we believe the market should be aware that some of these factors have been in play since late last year,” she said.
“In the near term, our tactical overweight on Indonesia remains in place given our expectation of a slight improvement in the external position – foreign reserves and trade balance.”
She suggests buying long-dated quasi-sovereigns such as Pertamina and PLN (Perusahaan Listrik Negara). Although the curve has compressed, these bonds are still trading wider than other ‘BBB’ rated Asian corporates, she said.
“After expected supply, we expect quasi-sovereign spreads to compress to levels in line with long-dated ‘BBB’ Asian corporates, which we estimate implies at least 15bp-20bp of compression. Apart from cheaper valuations, we think long dated quasi-sovereigns could also benefit from a potential bid from Taiwan life insurers.”