Overrated? Why ratings agencies could be a contrarian indicator

Emerging thinking

How does emerging market debt typically perform after being downgraded from investment grade? Does forced selling lead to underperformance or is it all in the price by then?

 

The debt of Russia and Brazil performed well after being downgraded from investment grade (or 'junked') in 2015. But does this pattern hold more broadly?

 

Several emerging markets (EMs) have been junked over the past three years, including Russia, Brazil, Turkey and South Africa. While EM ratings are now improving again on average, a few more EMs may get junked over the coming year or two, namely Colombia, Kazakhstan (both US dollar-denominated debt) and South Africa (local currency debt). 

 

So how does EM debt typically perform after being junked? Does forced selling lead to underperformance or is it all in the price by then?

The chart above shows the average performance of the debt of eight emerging market countries after they got junked by at least two agencies. This is all the instances where data is available; in total, there are 19 historical episodes of EMs being downgraded from investment grade by at least two agencies, but many were before performance data was available and others are so recent that they don’t have enough performance history.

 

According to the available data, the average (mean) EM has historically returned 12% in the year after being junked. Not only is this return significantly positive, it also exceeds the average historical 10% annual return in episodes without a downgrade from investment grade.

 

According to the data, the average EM has historically returned 12% after being 'junked'

 

The median historical return in examples where a country is downgraded is higher still at 20%. As the chart below shows, this is because the average return gets pulled down by Uruguay in 2003. In fact, seven out of these eight sovereigns delivered positive returns over the next year, while five out of the eight delivered above-average returns.

Getting junked, it seems, could be the perfect contrarian indicator.

 
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