As a result of the UK's decision to leave the EU, Standard & Poor’s (S&P) said that its AAA rating was “untenable under the circumstances”
and downgraded it to AA. Fitch reduced the UK’s rating from AA+ to AA while Moody’s assigned a “negative outlook” to the UK – the precursor to a downgrading.
Credit ratings have been considered essential to enable investors to assess whether they are receiving adequate compensation for the risk they are taking in lending their money to a particular government or company. They also warn investors of risky companies and give institutions that want to borrow money an incentive to improve their financial situation.
A downgrade should, in theory, make it more difficult and expensive for the UK government to borrow money: the lower a credit rating, the more likely the credit agency thinks the government or company is to default on its debts. This has traditionally resulted in lenders – other governments, institutional and retail investors – demanding higher interest rates in return for lending their money.
The value shares fell by in one month after S&P downgraded the US government's credit rating in 2011
But markets do not always react in the expected way following a warning or downgrading. Investors, desperate for security following the unexpected decision for the UK to quit the EU, have poured money into gilts, forcing prices up and yields down to a record low. Some yields have even become negative.
Investors reacted in a similar way in 2011, binge buying US Treasury bonds following a downgrading of the US government’s credit rating from AAA to AA+ by S&P
. After the downgrading, shares fell by over $6tn in under a month, but US Treasury bond prices rallied, with the cost of borrowing for the US government falling by 0.14 percentage point during the next 200 days, according to Bloomberg
In the past five years, investors have behaved in a similar way following rating downgrades in Austria, France, Japan, New Zealand, Finland and most recently Greece. According to data compiled by Bloomberg
, bond prices rose and interest rates declined during the 200 days following each downgrade.
Andrea Iannelli, Investment Director at Fidelity, said: “Rating agencies have historically been more backward looking and slower to react to events than markets, which have usually been quicker to adjust their expectations and factor them into asset prices. This has meant that on several occasions, by the time a rating revision occurred, the market had already anticipated it and discounted it, leading therefore to somewhat counterintuitive reactions, with bond prices rising following a downgrade.
“The downgrade of the UK credit rating by S&P and Fitch did not have a big market impact as they were largely expected by market participants. S&P in particular had already pre-warned that a victory by the Leave camp in the EU Referendum would lead to a downgrade, with markets that were therefore fully prepared.”
Rhys Petheram, a fixed income manager with Jupiter Asset Management, agrees that timing can dissipate the impact of a downgrading, but adds that a cut to a rating that still remains investment grade, is very different to one that becomes or is already high yield and is therefore regarded much higher risk. The UK may have suffered a downgrade, but it is still considered low risk and its debt high quality for those seeking safety during stock market turbulence.
How credit rating works
When assessing a government or company, a credit rating agency will consider a number of factors, including the institution’s level of debt, its character, proof of its willingness to repay its debt and its financial ability to repay its debt. But the service does have recognised flaws, and has come in for considerable criticism in recent years.
Much of the information used by credit rating agencies to evaluate institutions can be found on balance sheets and income statements. But some, such as attitude towards repaying debt, is subjective and down to the agency’s judgment. Critics claim this means that ratings for a debt instrument can vary too much from one agency to another, and that the agencies can also be inconsistent in their own judgments.
Petheram says that while consistency is important for defining whether a bond is investment grade (with a high credit rating) or high yield (low credit rating), ratings only vary “by a notch or two at most”. Professional investors understand the agencies’ different methodologies – Moody’s concentrates on the expected loss on default, for example, while S&P is more concerned with the probably of default – and know which agency analysts they trust for different sectors.
Although agencies conduct some ratings on an unsolicited basis to sell to investors, many assessments are requested and paid for by the institution seeking to raise money. One fund manager, who preferred not to be identified, said that companies issuing debt can use this to their own advantage. “They can pay for ratings by several agencies but only publish the one most favourable to them. I can think of at least two UK companies that have an investment grade rating from the same agency and no other ratings have been made available. But both companies have too much debt to be investment grade – they are really high yield.”
"The downgrade of the UK credit rating by S&P and Fitch did not have a big market impact as they were largely expected by market participants"
Most damning of all, the agencies have been accused of allowing their impartiality to be compromised, weakening their rating standards to gain new business.
An investigation by the US Senate into the origins of the 2008 financial crisis accused S&P and Moody’s of inflating the credit grades of sub-prime mortgage investments to AAA status to continue winning business from Wall Street banks. The agencies subsequently downgraded the vast majority of the bonds to junk status in July 2007, leading to the worst financial crisis since the Great Depression of the 1920s.
The Senate’s report said: “The rating companies were dependent upon those Wall Street firms to bring them business and were vulnerable to threats that the firms would take their business elsewhere if they did not get the ratings they wanted. Rating standards weakened as each credit rating agency competed to provide the most favourable rating to win business and greater market share. The result was a race to the bottom
Last year S&P paid $1.373bn to the US Justice Department and 19 states which had sued the agency for defrauding investors in the lead up to the financial crisis.
The global financial crisis has led to reform – both of the credit rating agencies and the financial institutions they rate. In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act has introduced oversight of the agencies, enforces rules to prevent conflicts of interest between agencies and their clients, and enables the revocation of registration for agencies that lack the resources to produce credit ratings with integrity.
There is evidence the credit ratings agencies’ experiences during the last decade have had an impact on their decisions in this one. Debt issued by US bank Lehman Brothers, one of the biggest casualties of the 2008 financial meltdown, still had a credit rating even as the bank filed for bankruptcy protection. In the UK, RBS and Lloyds were bailed out by the government. But last year S&P downgraded the ratings of six European banks including Lloyds, RBS and Barclays for fear that the government would refuse to offer them financial support in the event of another financial crisis.
The day after the UK Referendum, Bank of England Governor Mark Carney tried to reassure the markets that European legislation to improve the capital adequacy of banks had done much to shore up the position of those in the UK. Nevertheless, two weeks later S&P changed the ratings outlook for HSBC, Barclays, Lloyds and the UK arm of Santander from stable to negative, while RBS dropped from positive to stable.
The amount S&P paid to the US Justice Department and state partners for defrauding investors in the lead up to the financial crisis
Credit rating agencies have tried hard to restore their reputations. When the Department of Justice filed its civil lawsuit against S&P in 2013, the agency said it had taken to heart the lessons learned from the financial crisis. “In the past five years, we have spent approximately $400m to reinforce the integrity, independence and performance of our ratings. We also brought in new leadership, instituted new governance and enhanced risk management. Based on what we learned, we changed the way we rate almost every type of security that was affected by the financial crisis.”
Has it worked? In 2011 when Moody’s downgraded Portugal to junk status, German Finance Minister Wolfgang Schäuble said that he wanted to “break the oligopoly of the ratings agencies” and limit their influence. Five years on, one fund manager said he thinks the big three agencies – S&P, Moody’s and Fitch – still have too much power, and that smaller agencies continue to suffer from a conflict between protecting their integrity and needing to attract business.
But Jupiter’s Petheram says the quality of ratings is not an issue. “If a company is issuing a bond, six analysts will be involved in rating it, including two with ten years’ experience and a further two with 20 to 30 years’ experience. For me, that’s enough.”