Analyst Note On The Downgrade Of Nigeria’s Sovereign Risk Rating By Moody’s
By Arthur Stevens Asset Management Ltd
The Nigeria Government sovereign bond was downgraded to Caa1 from B3 in a recent release by Moody’s Investors Service (“Moody’s”), one of the top three credit rating companies in the world, indicating that the country has been downgraded by one notch, implying that the high speculative status of the Nigerian debt instrument has further deteriorated into the substantial risk status. Moody’s downgrade follows Fitch’s recent downgrade of Nigeria in November 2022, sending negative signals to investors, particularly foreign investors.
The Government of Nigeria’s long-term foreign-currency and local-currency issuer ratings, as well as its foreign currency senior unsecured debt ratings, were downgraded in the report, but the outlook remains stable. In general, a stable outlook implies that the risk of the government defaulting is low.
Even if there is fiscal imbalance, the government can still service its debt in the short term.
The credit downgrade of Nigeria’s sovereign bond has implications.
Some of the broad implications are as follows:
1. Increased borrowing costs: A lower credit rating typically indicates that the country is a higher risk borrower, which may result in higher interest rates on its sovereign bonds. This rise in borrowing costs may have a negative impact on the Nigerian government’s ability to fund its budget, as the country is already dealing with high debt servicing.
2. Currency depreciation: The credit downgrade may reduce investor confidence in the Nigerian economy, leading to capital flight and a depreciation of the Nigerian naira as demand for dollars rises amid the economy’s dollar crunch.
3. Decreased investment in debt instruments: A credit downgrade may discourage foreign investment in Nigerian financial markets, resulting in lower capital inflows and lower economic activity as available funds for investment are reduced.
4. Market volatility: As investors adjust their portfolios to reflect the change in the country’s creditworthiness, market volatility may increase. This volatility may reduce market liquidity, making it more difficult for businesses to obtain capital and finance their operations.
5. Reputational harm: The credit downgrade may harm the Nigerian government’s and financial markets’ reputations, making it more difficult to attract investment and finance development projects in the future.
Implication to the financial market
Fixed Income Market:
There inverse relationship between credit rating and interest rate. In other words, the less risky the company, the lower the interest rate required by investors. The credit rating downgrade will have the following implications:
1. To compensate investors for the additional risk, the country will have to borrow at a higher interest rate. Although higher interest should ideally attract investors, institutional and foreign investors may take a contrarian approach.
2. It is commonly assumed that sovereign bonds have no default risk. However, if the government’s credit rating is downgraded, corporate bonds will suffer a similar downgrade, increasing their borrowing costs.
3. With a higher risk, investors will most likely reduce their exposure to the fixed income market, reducing liquidity and causing yields to rise, causing prices to fall and increasing price risk.
The following are the likely ramifications of the credit rating downgrade on the equities market:
1. Adjustment of portfolio investments in fixed income instruments in favor of equities to manage potential default risk in the face of high inflationary pressure.
2. Earnings have been a major driver of the equity market, and rising interest rates may result in a profit squeeze for firms, influencing investor reaction in the long run.
The downgrade introduces nuances to market expectations, which must be taken into account. The downgrade foreshadows the government’s deteriorating credit situation, which could lead to a likely default in the medium to long run if nothing strategic is done. Although, as evidenced by Ghana’s inability to meet its debt servicing obligations, the Nigerian government may be on the verge of suspending its debt servicing obligations if certain fiscal changes are not implemented, which will obviously suffer the impact lag. While we wait for the long process of improving the country’s credit rating, we recommend the following:
1. Reducing positions in longer maturity bonds and increasing positions in shorter to medium term maturity bonds while waiting for government finances to improve.
2. Shorting longer maturity bonds trading at a premium
3. Equities of less geared firms with a good dividend track record and a positive historical correlation with the equities market, which we believe will be bullish in 2023 should be longed.
•Arthur Stevens Asset Management Ltd can be reached at firstname.lastname@example.org