Q&A

What are credit ratings?

Delivered primarily by three ratings agencies – Standard & Poor’s (S&P), Fitch and Moody’s – credit ratings are an assessment of a borrower’s ability to meet its financial obligations fully and on time.

Ratings can be applied to issuers such as companies, individual debt issues such as mortgage-backed securities, and countries, also known as sovereigns.

Credit-rating agencies have been criticised on many fronts in recent years – for having an oligopolistic hold on the sector, for inaccurately rating subprime securities and thereby contributing to the credit crisis, and for prematurely downgrading sovereigns such as Greece in 2010. But their decisions still have a critical impact on financial markets.

Why are they important?

Sovereign debt ratings are used to assess how likely a country is to repay its debt, and therefore how much of a return an investor should look for to hold the debt – ie government bonds or treasuries – of a particular country. Typically, the riskier the bond, the greater the price investors are paid to hold it. So the lower the rating the greater the cost of financing for a country.

Following the US downgrade, only a handful of countries, including France, Germany, Luxembourg and the UK, can now boast of having an AAA rating. Ireland was recently downgraded to junk status by Moody’s (Ba1).

Why was the US downgraded?

The US lost its "gold-plated" or AAA status from S &P primarily because it failed to reach political consensus effectively on how it can adequately resolve its $14.3 trillion (€9.98 trillion) debt crisis. It is now rated AA+ with a "negative" outlook.

Despite this month’s debt deal, which would involve $2.5 trillion in spending cuts over the next decade, S&P has argued that greater savings – in the order of $4 trillion – are needed for the US economy to reduce its deficit.

S&P also warned that it wants to see more political consensus than it has seen thus far before it considers upgrading the US.

What will the impact of this be?

The most immediate impact of a rating downgrade is that it increases the cost of funding.

Investors will now demand more of a return, in the form of a higher interest rate, for holding US government debt, known as treasuries.

However, given that most interest rates in the US are priced in relation to the US treasury benchmark, this also means the cost of other borrowings such as mortgages and loans may rise. So it is likely to have a significant impact on the real American economy and will hit the average US consumer by pushing up borrowing costs.

In addition, government- sponsored institutions such as mortgage buyers Fannie Mae and Freddie Mac may be downgraded, although S&P will only disclose its intention in this regard today.

In the long term, the decision could affect the US’s reputation as a safe haven, eroding the position of the dollar as the global currency and sending yields of treasuries upwards. It also heightens fears that the US economy will fall back into recession.

How have investors reacted?

When Ireland was downgraded, yields on Government bonds hit euro-era highs as investors sold off their holdings, but the outlook for the US looks more uncertain.

Given the US position as a safe haven, this is seen as more unlikely. Indeed, yields on US treasuries have tightened over the past month despite S&P’s warnings that it might downgrade the sovereign.

While some investors may be required to keep their money in safer, AAA-rated economies, the US remains the largest, and therefore most liquid, bond market, so investors are likely to stick it out.

Some analysts suggest that, given the carnage on the equity markets, investors looking for a safe haven will continue to put money into treasuries, pushing yields down.

The biggest holder of US treasuries is the US Federal Reserve. But the next biggest is China, with $1.6 trillion in treasury securities, and it has taken the opportunity to call for a “new, stable and secured global reserve currency”.