Australia’s sovereign credit rating has been put on a credit watch by Standard & Poor’s, moving its outlook from ‘stable’ to ‘negative’. This means a downgrade from AAA to AA is on the cards – the first downgrade from S&P since 1989.

Sovereign credit ratings are a measure of a country’s creditworthiness, but also show how stable and resilient to shocks an economy is. AAA economies are classed as ‘investor grade’ and are a strong pull factor for international property investors.

Australia has had a AAA sovereign rating from the major credit agencies, S&P and Moody’s, since 2003. Its AAA rating withstood the GFC, showing the economy is resilient to global shocks – a desirable trait to have in today’s volatile global economy.

A downgrade would certainly make headlines. But do the property markets care as much as the newspapers do?

Commercial yield-to-bond spreads have continued to widen despite six rating changes

Over 1986 – 2016, commercial property yields have continued to widen relative to the ten-year inflation-indexed bond rate which is the risk-free rate.

If credit ratings were a factor in office yields, we might expect to see yields widen in response to ratings downgrades and vice versa. In fact the long-term trend seems to be in the opposite direction. This suggests that there are broader factors at work here. For example, currently real bond yields in Australia are near all-time lows – as they are in most global markets.

At the margin, in the quarters either side of a rating change, the short term effect has been minor. Only after Australia was downgraded in 1989 from AA+ to AA did the prime office yield spread to the real bond rate change substantially, narrowing by 65 basis points (-43%) from 4Q89 to 1Q90. However at the same time the Reserve Bank cut its policy rate by 160 basis points.

Figure 1: Australia: National prime office yield and real bond rate vs S&P ratings, 1986 – 2016
Source: JLL Research, Reserve Bank of Australia

Residential mortgage loans have been priced independently of sovereign ratings

In the residential market, mortgage rates have moved independently of sovereign ratings between 1996 – 2016, based on the spread between the official interest rate and the average variable home loan rate offered by Australian banks.

Figure 2: Average variable home loan rate spread to official interest rate vs S&P and
Moody’s ratings, 1996 – 2016
Source: JLL Research, Reserve Bank of Australia

For a period around the turn of the millennium, it was standard practice for Australian banks to closely match their mortgage loan rate to the official cash rate. This relationship persisted despite two rating upgrades, and over a period when the cash rate varied between 4.25% and 7.50%.

Since the Global Financial Crisis in 2007 the domestic banks have started to widen the spread. This reflects increased competition for deposits in the local market as they seek to reduce their dependence on offshore sources of finance. This further illustrates the insignificant role that rating changes have on the Australian residential property market.

Using history as our guide, we can anticipate that property markets will shrug off a possible downgrade to Australia’s AAA rating.

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