How Important are Credit Ratings?

Readers question: What will happen if the UK has its credit rating reduced from AAA to AA?

Do you remember all those sub-prime mortgage bundles which caused the credit crisis? These mortgage bundles which later proved to be almost worthless were, for a considerable period, given a AAA credit rating by rating agencies. Even Greece, now on the verge of insolvency, maintained an A credit rating until May 2009. (Bond yields at Datosmacro) What did a credit rating of A mean for Greece? It meant the credit rating agencies didn’t really know what was coming quite soon. (nor the rest of the market either)

Credit rating agencies have no greater ability to predict future defaults and financial flows than anyone else in the market. Someone once described fiscal policy like driving a car by looking out of the rear view mirror. (You can only look at past data.) To some extent, it’s the same with credit rating agencies. They are looking at data taken from the past.

If a credit rating agency moves a country from AAA to AA-, it doesn’t really add any extra data to investors and buyers of bonds.

Because credit ratings are a highly visible signal, they can perhaps gain more political importance than they perhaps deserve. A triple AAA credit rating sounds good. Plus, it’s much easier to explain to the public than the ‘merits of expansionary fiscal policy in a liquidity trap’.

This is not to say Credit ratings are entirely worthless. Portugal with a B rating compared to the UK’s of AAA is a signal reflecting the fact the Portuguese debt situation is worse than the UK. (although just to complicate things –  Portugal budget deficit is lower than UK, but Portugal don’t have their own currency and have a deeper recession)

What Actually Determines Credit Rating?

In justifying austerity measures, the UK government made much of the fact that we must protect our AAA credit rating. Without a credible plan to reduce debt to GDP ratio in the future, our credit rating would be cut, interest rates will rise, and we could end up like Greece / Portugal / Spain. It’s not entirely without merit. If you allow your debt to GDP ratio to significantly increase, investors (at some point) will start to get nervous and demand higher interest rates.

However, the problem is that simple fiscal consolidation measures (cutting spending, raising taxes) have in the current economic climate, caused a big negative multiplier effect, lower economic growth and therefore a higher cyclical deficit. In the UK’s case, disappointing economic growth (at least partly related to austerity measures) have meant tax revenues have dissappointed, and GDP fallen. Therefore, with lower economic growth, the debt to GDP ratio is rising faster than anticipated. Arguably, there was no rush to reduce the deficit, and the government worried over invisible bond vigilantes.

Furthermore, fears over the UK’s credit rating are closely linked to the continued downgrading of economic growth.

From one perspective, it seems that credit ratings can downgrade you because debt is too high. But, when you try and reduce your deficit – causing a double dip recession, you have your credit rating reduced anyway.

  • To be a little mischievous – credit rating agencies call for austerity. But, when austerity causes a recession, you get downgraded because of the policies the credit rating agency asked for.
  • What determines credit ratings?

Does a reduction in Your Credit Rating Push up Interest rates?

  • Over the past few years, Fitch have downgraded Japan’s credit rating from AAA to just A. But, it hasn’t stopped a fall in Japanese bond yields (See: why Japan bond yields fell)
  • Standard & Poor downgraded the U.S. credit rating from AAA to AA+ in August of 2011. But, US bond yields kept falling.
  • In the case of European bond yields – credit ratings were cut as bond yields rose.

The point is, credit rating agencies have a poor track record of predicting rising bond yields. But, that is to be expected, why should Credit rating agencies have knowledge that bond investors don’t have? If credit rating agencies really could predict insolvency and liquidity crisis before the rest of the market, they could probably be making a lot more money on buying options in the right government bonds.

However, it is equally possible, that if the UK’s credit rating was cut, bond yields may later increase. But, it won’t be directly related to the decision of the credit rating agency.

The fact which would probably cause quickest increase in bond yields would be signs of economic growth.

Credit Rating and Poor Decisions

Some even argue that credit ratings do more harm than good. If you see a  security has a triple AAA rating, you probably assume, there’s no need to investigate further. It must be fine. Perhaps with credit rating agencies, banks may have investigated all these sub-prime mortgage bundles a little more closely. Perhaps they would still have bought, but it shows you can’t always believe a credit rating agency.

In the case of the UK, the pursuit of a AAA credit rating is really a false goal. If we pursue economic recovery and lower unemployment, government borrowing will be in a much better position than if we pursue self-defeating austerity.

Junk Bonds

Junk bonds are a term given to bonds where there is no guarantee of repayment. This will apply to new firms or risky business investments such as biotech companies.

By giving ratings to various bond markets, investors are able to make better decision about which bonds to invest in. For example, junk bonds will invariably need to offer a better interest rate to compensate for the increased risk.


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