FP Explainer

What Makes Credit Rating Agencies Issue a Downgrade?

What Makes Credit Rating Agencies Issue a Downgrade?

It’s been a big week for credit rating agencies in global politics. On Wednesday, July 13, rating service Moody’s (you might remember them from the subprime mortgage crisis) announced that U.S. bonds are ripe for a possible downgrade from AAA status as the political deadlock in Washington continues over raising the debt ceiling — which regulates how much the U.S. government can borrow. On Tuesday, the agency downgraded Irish bonds to "junk" status. The country now joins Portugal, which was downgraded last week, and Greece as the European countries whose bonds are no longer considered investment grade. So what exactly determines these scores?

The ratings are a measure of how risky an investment a country’s bonds are; they range from AAA (highest) to C (lowest). A country with a credit rating of BBB or higher is considered "investment grade;" below that is "junk."

To determine the rating, the agencies look at two main factors: One is economic (the country’s ability to pay off its debts), and one is political (whether the government is willing to). The economic criteria include the country’s revenue, fiscal and monetary policies, budgetary flexibility, level of inflation, public debt burden, and economic track record. On these criteria, the United States certainly merits its AAA rating; it’s more or less taken as a given in global finance that U.S. government bonds are among the safest investments. On the other side of the spectrum there’s Greece, where public debt is expected to reach 161 percent of GDP next year, its membership in the eurozone precludes simply printing more money to pay off loans, and a default is now considered a realistic possibility.

In the U.S. case, the threat of downgrade is due to political, not economic, reasons. Washington could easily continue borrowing money in order to pay off bondholders. But unless Congress and the White House can reach a deal to raise the $14.3 trillion debt ceiling by Aug. 2, the United States will be legally unable to do so. The latest announcement from Moody’s essentially amounts to a warning to Capitol Hill and the White House that the global financial community isn’t amused by the partisan bickering. 

A downgrade from AAA to AA is not, in itself, a catastrophe. Japan’s credit rating has been steadily downgraded for years — not exactly a vote of confidence, but even at AA-, the risk of a Japanese government default is pretty minor.

A downgrade from investment-grade to junk status is much more serious. Most major fiduciary firms, such as pension planners and insurers, are forbidden from investing in junk bonds. That means that countries like Ireland, Portugal, and Greece now have a much smaller group of investors who can buy their bonds. Those that can and do, of course, will demand a much higher rate of interest to account for the increased risk of their investment.

An actual default — even a brief "technical" one — of the U.S. economy could be cataclysmic, as it would lower the country’s credit rating, resulting in higher interest rates and raising the Treasury’s borrowing costs by billions. Think of it as the consequence of not paying your mortgage or credit card bills. An extended failure to repay bondholders could lower the rating to a point at which mutual funds will be required to divest, forcing a sell-off of trillions of dollars in bonds.

It wouldn’t be pretty.

Thanks to Peter Marber, chief business strategist for emerging markets at HSBC Global Asset Management.