What do credit ratings mean?
Once again the credit rating agencies are in the news. In the aftermath of S&P’s announcement that if Europe falls into another recession they will likely downgrade France, Spain, Italy Ireland and Portugal, an EU commissioner has suggested that sovereign ratings be banned for countries in bailout talks.
Of course it is fundamentally foolish to outlawing a messenger when the news is bad; kind of like banning weather reports when we don’t like the weather. But we can also ask what a sovereign credit rating accomplishes.
Ostensibly, it measures the probability of default—of investors not receiving principal or interest as scheduled. For bonds, that is perhaps the most important issue to an investor, and significantly affects how much an issuer will have to pay. A bond issued by Exxon-Mobil is significantly less risky than one issued by Denny’s restaurants.
But it’s a lot trickier when you evaluate the debt of sovereign nations. When a country runs a chronic deficit that is greater than its potential for economic growth, that debt will eventually overwhelm the nation’s finances. If it’s due to temporary factors, those can be adjusted for and the debt paid off—as happened in England in the 19th century and the US in the 20th. But if the borrower can’t grow fast enough, it has to reduce its expenses, or default.
There are well-tested metrics of default-risk: liquidity, solvency, efficiency, and so on. We use them ourselves. And liquid markets make credit decisions every time a bond changes hands. So in many ways ratings agencies are irrelevant. But summarizing credit risk in a simple serves a useful function.
Just remember that ratings agencies are subject to herd behavior like every other market player. And no matter what the rating, Moody’s doesn’t pay the coupon.
Douglas R. Tengdin, CFA
Chief Investment Officer
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