S&P Sovereign rating explained - How nations are downgraded/ upgraded
One of my finance focussed friends in another MBA college is taking Marketing subjects instead of Finance subjects as electives in term five. I asked her over Facebook “Hey, investment banker, what happened?” The lady replied in typical finance lingo – “I am reducing risk by diversifying my portfolio.
Recession is waiting for our placement, you know”. I was thinking which recession is this lady talking about? But when seen in the backdrop of a US rating downgrade, this conversation suddenly started making sense.
What is S&P?
S&P (Standards and Poor’s) is one of the leading credit rating agency (CRA) based out of US. It is part of publishing company The McGraw-Hill. Apart from credit ratings, it is also famous for its indices such as – S&P 500, S&P CNX Nifty.
What are credit ratings?
Credit ratings express the opinion of the CRA about the ability and willingness of the issuer of any debt-like security to meet its promised obligations. These ratings can be issued for entities such as companies or governments of countries and states. In this regard, they express the opinion of the CRA about the risk of default of the issuer of this debt-like security. If the risk characteristics of a particular kind of debt issue are different from that of the issuing entity, then credit ratings can also be issued for individual issues rather than the overall rating of the issuer. For example, if ABC Corp issues a debenture the proceeds of which are directly linked to returns from an investment project it is considering, the rating for this debenture would reflect the risk of this project and not the risk of ABC Corp.
Credit ratings are normally provided by CRAs such as Standard & Poor’s, Moody’s and Fitch, which specialize in evaluating credit risk. The methodology applied by the CRAs is quite similar since they are trying to model the same risks. Typically, ratings are expressed as letter grades that range, for example, from ‘AAA’ to ‘D’ to communicate the agency’s opinion of relative level of credit risk.
What do the letter ratings mean?
The meaning of the letter ratings as given by S&P on their website is given below .
‘AAA’—Extremely strong capacity to meet financial commitments. Highest Rating.
‘AA’—Very strong capacity to meet financial commitments.
‘A’—Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
‘BBB’—Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.
‘BBB-‘—Considered lowest investment grade by market participants.
‘BB+’—Considered highest speculative grade by market participants.
‘BB’—Less vulnerable in the near-term but faces major on-going uncertainties to adverse business, financial and economic conditions.
Why do credit ratings change?
Rating changes may be due to systemic changes which affect a multitude of industries and companies such as changes in economic growth, changes in regulatory environment or changes in market interest rates. Alternatively rating changes may reflect the changes in the risk characteristics of the industry, the company or the particular debt issue.
To put this in perspective, an industry specific change such as the advent of computers adversely impacted the expected future performance of all typewriter companies and hence was expected to result in a credit rating downgrade of all typewriter companies. Increase in debt burdens and over-investment issues such as heavy capital expenditures without proportionate increase in market demand are some of the other examples which may cause rating downgrades.
What is sovereign credit rating?
A sovereign credit rating assigned to its national government. This rating is an indication of the investment environment in a country and includes risks such as political risk of the country. To understand things more clearly, let us divide risk into two types- sovereign risk and country risk. Sovereign risk considers the probability of default by the government of the country. Recent failures of European governments such as Greece highlight the importance and possibility of this occurrence. The sovereign rating of a country is thus an upper limit for ratings of other entities within the country since the risks of all entities include the risks of the government default. Country risk, on the other hand, considers the risk factors inherent in an economy such as GDP growth, interest rates and regulatory changes.
Why S&P has downgraded US rating?
S&P downgraded the long-term credit rating of US from ‘AAA’ to 'AA+' last month. This was due to the perception that the rising sovereign debt of US and increasing political risk would slow down US economic growth. This basically reflects the opinion of S&P analysts that the fiscal plans that the US government has recently agreed to would not be enough to service the high sovereign debt of the country.
This downgrade is also a sign of the opinion that the credibility of any economic and political policymaking is questionable. Given the recent financial crisis and the economic challenges faced by the US government, this reflects the view of S&P analysts that the predictability of US government’s policymaking has weakened since the rating was given a negative outlook on April 18, 2011.
The bigger issue is not just that the rating was downgraded but also the fact that the rating outlook is still negative. This implies that the long-term rating could be further downgraded in future if the actual government spending is lesser than normal. The negative outlook further strengthens the opinion that the ability of the US government to deal with any further shocks is limited given its high debt position. This is further exacerbated by the problem that it would become increasingly difficult for the US government to raise new debt as the economic consequences of such actions are highly negative.
What is the impact of this rating downgrade?
The rating downgrade can have serious implications in a global economy. To begin with, a rating downgrade increases the costs of borrowing and reduces the investability of US markets by outside investors. This might reduce the money supply necessary to fuel the growth of US. If the economic growth is slowed due to a liquidity crisis precipitated by a rating downgrade, it would affect all countries which trade with the US directly or indirectly. A country such as Japan which exports good or India which exports services (in the form of call centres, software services and KPOs) would be impacted seriously in terms of its own growth, especially if exports form a significant portion of the country’s GDP. Thus, the profitability and employment status of software, export oriented manufacturing and BPO/KPO firms would be adversely affected.
- 4 things entrepreneurs must consider while
0 Comments - 2 weeks 1 day ago
- Project Prioritisation and Application of Decision
0 Comments - 2 weeks 4 days ago
- Merger and Acquisition: A Strategic Valuation
0 Comments - 3 weeks 2 days ago
- Mobile Banking: A Wallet for all Pockets
0 Comments - 4 weeks 6 days ago