Bond credit ratings
The world of bond credit ratings is a slightly odd one. They’re important for private sector issuers of bonds and also, more rarely, to holders of them or investors in them. To government issuers they don’t matter in the slightest and only rarely to investors on government bonds.
The private sector importance is that no set of investors has the time to truly investigate all the issuers out there. So, a lot of the work on new issues is done by the bond rating company. The issuers hire the ratings company to then tell the world their opinion about the bond. This feeds through into the pricing of the bond as any specific rating will mean the issue is priced at about or around market for that rating.
Such ratings obviously aid investors in deciding whether to invest, that’s why the issuers pays. But for the investor it’s a guide to action, not a necessity. Except when the bond fund – say – says that it only invests in AA or better, or in commercial grade, or in distressed, junk and so on. As the fund is defining its investment strategy by rating then clearly it has to obey its own description of itself and invest by rating.
Investors in government bonds might have that same sort of issue. But government issuers don’t. For they don’t need to have a rating at all. As it happens some smaller governments do on that basis above – having one indicates to investors something about the quality of the bond and borrower. So, out of self-interest they pay for one.
Larger governments (UK, US, just as two examples) don’t bother. The ratings agencies still supply them but more as a matter of PR than anything else. The issuers aren’t paying them for them and nor are investors. Further, if we get to the point that major issuers like that are going to be less than commercial (say) grade then we’ve all got much greater problems than who is or is not doing the ratings. Even then, often enough, government bonds will be regarded as sound for regulatory purposes, removing the restrictions upon investors taking positions in them.
So, sovereign ratings aren’t paid for, they’re also not really necessary for investors in any likely set of situations. Thus Moody’s downgrading the UK doesn’t mean very much:
Moody’s Investors Service (“Moodys”) has today downgraded the government of the United Kingdom’s long-term issuer and senior unsecured ratings to Aa3 from Aa2. Concurrently, the outlook has changed to stable from negative.
No one who used to buy these bonds now cannot, regulatory treatment hasn’t changed, it’s not some big change here.
Another bond rating thing
It’s fair to say that upon issue – for private sector borrowers – that ratings are market leading. The rate at issue will determine the price at issue to a great extent. However, after that they tend to be market following.
That is, the agency changing the rating doesn’t change the price of the bond in the markets. Sure, it could, in theory, even can if the rerating comes entirely out of the blue. But they very rarely do so. Instead the information that something has changed becomes generally available to the market, prices change, the rating change then following after all the price action. The agency is reacting rather more to market price changes than causing them.
So, what’s changed?
As Moody’s points out, things have changed in Britain. None of this being a surprise to the wider markets at all:
Negative long-term structural dynamics have been exacerbated by the decision to leave the EU
OK, Brexit and the absence of a trade deal.
Growth will also be damaged by the scarring that is likely to be the legacy of the coronavirus pandemic
OK, they’re expecting reduced growth in hte future as a result of the damage done by the oronavirus and lockdown. That’s not certain but it’s entirely possible.
Second, the UK’s fiscal strength has eroded
Yes, clearly, the country has borrowed vast sums in order to pay for the lockdown. And that’s on top of the fiscal ravages of the past decade.
The third driver relates to the weakening in the UK’s institutions and governance that Moody’s has observed in recent years
This is rather coded but basically no one at all is worrying about debt dynamics so we should be worried about debt dynamics.
All reasonable although we can argue with any and all of them. I’d suggest that Breit is going to produce a burst of growth but then given my position on Brexit itself I would say that, wouldn’t I?
So, there’s nothing wrong with any of their ideas and we could – could – agree with them all. However, there’s nothing in there that’s not already available to the market. Indeed, much of the market response has already happened. The decline of sterling in the past few years is entirely due to Brexit and worries about that trade deal that doesn’t seem to be about to happen. In the jargon, that will lead to a change in the terms of trade and a change in th terms of trade leads to a change in the value of the currency.
The metric XXXtonne of debt is hardly a surprise to anyone and so on. This change in the rating is reactive to events, not causative that is, as up at the top.
It doesn’t actually matter
A change in rating can indeed have an effect on the value of privately issued debt. Again, usually, it’s reactive – the damage has been done, the price slipped already, then the ratings agency speaks. But it’s also possible to a ratings change to mean certain funds can’t hold the debt any more – that means it can still move prices as holdings are changed. Even then a lot of the price change happens beforehand as people surmise that it’s coming.
That doesn’t happen with sovereigns for the people who define what may be held are the sovereigns. And there’s just no way that the British government is going to start saying that British government debt cannot be held by a pension fund, as one example.
But it doesn’t matter for another reason. We don’t have a market price for UK Gilts (the name for UK government debt) at present anyway. Pretty much everything that has been issued this year has been bought by the Bank of England under QE. So too another £400 billion or so of debt in recent years.
The determinant of gilts prices currently is the Bank of England and pretty much nothing else. Sure, there are minor wibbles this way and that but absolutely nothing matters as much as the BoE and their balance sheet.
So, changes in gilts prices will be driven by policy at the BoE, not whatever Moody’s says.
I agree with Moody’s that the three (well, two under one banner, then two more) issues they mention are worth worrying about. I differ in my expected result from Brexit but that’s still to worry about it. And those who lend to governments are right to worry when a government starts to make a drunken sailor look financially prudent.
Yes, the British government is less credit worthy than it was and they’re right to say so.
The investor view
Even as Moody’s is right it doesn’t matter for any investor with a less than decadal time horizon. Because what the credit rating is simply isn’t going to be the determinant of government debt pricing until the QE issue is resolved. Will it lead to inflation? Will the balance sheet thus be reduced pushing up interest rates? Or have the normal money supply rules gone out the window and we’re not going to get inflation from a massive increase in base money? These are the issues that matter for gilts pricing, not the credit rating.
Moody’s action is interesting but not important to us as investors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.