Credit rating agencies continue to be busy, downgrading a record-number of countries this year. Poor old Britain even lost two notches from S&P! Now the Land Down Under is in their sights, causing some to suggest raters are “tightening the screws” on the banking system—presuming a lower-rated Australian Federal government will boost borrowing costs for banks, other firms and states downstream. Here we advise relaxing. Have a Coke. Smile. As ever, raters are acting and jawboning based on flawed assumptions, arbitrary observations, myths and widely known information, none of it actionable for investors.
Rating agencies’ recent downgrades are based on flawed methodology, philosophy and process, which is sort of par for the course for them historically. S&P and Fitch downgraded the UK in the days following June’s Brexit vote, saying Brexit might reduce foreign investment and increase political gridlock. However, bond markets either don’t think these events are likely to come to fruition or don’t agree that they present a credit risk for Britain, as yields have fallen to historic lows since the downgrades amid strong demand at Gilt auctions. There is no evidence Britain relies on “the kindness of [foreign] strangers” to fund its debt.
Soon after, S&P put Australia on negative watch because political gridlock may prevent it from passing measures aimed at reducing its budget deficit, which has ballooned in recent years. But Australia’s net debt-to-GDP ratio—at 18.9%— is much lower than that of the US, UK and all major European nations. The Aussies can easily service their debt. Earlier this year, S&P downgraded Poland after it passed laws S&P claimed weakened key institutions, and all three raters downgraded Brazil to junk status this year amid continued political turmoil and rising debt relative to GDP. But these factors don’t mean these countries’ creditworthiness is imperiled. More political influence over banks and the media isn’t a good thing, but it’s a far cry from being at greater risk of defaulting. As for rising debt, this is a problem only if it increases enough to jeopardize a country’s ability to make debt payments. This is not the case for Brazil, which has a huge piggy bank stuffed with forex reserves. Besides, in each of these cases, the events S&P cites have already happened—markets likely already reflect them.
Raters have a long history of making arbitrary, backward-looking decisions. In 2011, S&P downgraded the US based on the notion political brinkmanship surrounding debt ceiling debates would hamper efforts to rein in rising debt levels. The downgrade was also based on a math error that overstated projected budget deficits by $2 trillion. Since then, even as overall debt has risen, interest payments’ share of revenues declined as interest rates fell and revenues rose. Both Fitch and Moody’s downgraded the UK in 2013, citing the UK’s inability to reach its self-imposed deficit reduction targets as their rationale. But those targets were selected for political reasons, not financial ones. It isn’t as if pols have special insight into the exact deficit levels that distinguish creditworthy from credit risk. Since those downgrades, annual budget deficits fell because economic conditions improved and borrowing rates declined, consistent with the recent global trend. But even so, deficit reduction still consistently missed budget targets! Raters chose to conveniently ignore those misses. From 2013 – 2015, all three raters downgraded France, claiming weak growth rates would supposedly make it harder for the country to reduce its debt. But, according to Global Financial Data’s record-keeping, French borrowing rates have since fallen to their lowest levels in 270 years, a sign lenders believe France isn’t a material credit risk even though its budget deficits and debt have risen.[i] If these downgrades didn’t signify these nations’ creditworthiness had actually deteriorated, why should their claims be any more useful now? Anybody? [Crickets]
Ratings agency decisions may garner scary headlines, but they aren’t meaningful for investors. They largely don’t cause bond yields to rise. Sometimes yields rise in the run-up to downgrades, but then fall after. This happened in the US, France and other countries over the last several years. Rising sovereign debt and political gridlock in the US, UK and elsewhere have been widely discussed for years. That bond yields are as low as they are suggests bond investors are well aware of these issues and don’t believe they cause countries to be less creditworthy. Seems about right to us. Absolute debt levels don’t matter. Only a country’s ability to service it does. As for political gridlock, this is just as much a positive for bonds as it is for stocks. It makes it less likely government passes a lot of broad, sweeping legislation that stokes uncertainty, roiling markets.
So why do rating agencies’ decisions get so much attention? Because years ago, governments globally enshrined ratings in bank regulation—a way to define whether certain assets qualified as high-quality capital or not. In America, Congress even created an oligopology by granting Moody’s, Fitch and S&P special status to issue said ratings, as Nationally Recognized Statistical Rating Organizations (NRSROs). Other institutional investors followed this precedent, using NRSRO ratings as a portfolio guideline. But these are arbitrary rules. After the US was downgraded, many institutional investors just changed their guidelines. The Fed confirmed that for banks, Treasurys’ weightings for satisfying capital requirements won’t change. Problem solved.
Instead of taking cues from rating agencies, take them from the market. With global long-term bond yields at historic lows, markets are telling us most major developed countries can service their debt, and will likely continue to do so for the foreseeable future. Sure, yields are ultra-low partly because central banks are buying sovereign debt in droves, but this isn’t the only source of demand. Institutional and retail investors are perfectly willing to accept low yields, a sign there just isn’t much default risk to compensate for.
[i] Source: Global Financial Data, Inc., as of 7/20/2016. France 10-Year Government Bond yields, 1746 – 2016. Yes, we do think data from the 18th and 19th centuries are dodgy, so consider this more a fun factoid than an ironclad record of bond yields under Maximillian Robespierre. That said, we figure the data covering the 20th and 21st centuries are probably pretty sound.