Credit-ratings agencies were awfully busy last year, downgrading a record number of sovereigns that run the gamut from commodity-heavy emerging market nations to major developed countries like the U.K.
They're following that up with more this year, with Moody's cutting China in late May and Moody's and S&P both warning they would consider cutting the U.K. (again) after this year's general election result came in. The state of Illinois was recently downgraded to junk and Qatar was cut last week. So is this a sign of bond-market trouble ahead?
In our view, no. Rating agencies' recent downgrades are based on flawed methodology, philosophy and process, which is sort of par for the course for them historically. Last year's S&P and Fitch downgrade of the U.K. followed June's Brexit vote, with the raters arguing Brexit might reduce foreign investment and increase political gridlock. However, bond markets either didn't think those events were likely to come to fruition or didn't agree that they presented a credit risk for Britain, as yields fell to historic lows after the downgrades amid strong demand at gilt auctions.
Next, S&P put Australia on negative watch, arguing political gridlock would prevent it from passing measures aimed at reducing its budget deficit, which is up in recent years. But Australia's net debt-to-GDP ratio is expected to be 19.2% in fiscal 2017-2018 -- much lower the U.S., U.K. and all major European nations. The Aussies seem to be able to easily service their debt.
Last year, S&P downgraded Poland after it passed laws S&P claimed weakened key institutions, and all three raters downgraded Brazil to junk status amid continued political turmoil and rising debt relative to GDP.
But these factors don't mean these countries' creditworthiness was imperiled. More political influence over banks and the media wasn'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. That wasn't the case for Brazil, which has a huge piggy bank stuffed with forex reserves. Besides, in each of these cases, the events S&P cited had already happened -- markets likely already reflected them.
Raters have a long history of making arbitrary, backward-looking decisions. In 2011, S&P downgraded the U.S. 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 U.K. in 2013, citing the U.K.'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 to 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 proceeded to fall to their lowest levels in 270 years after those moves, a sign lenders believed France wasn't a material credit risk.[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 U.S., France and other countries over the past several years. Rising sovereign debt and political gridlock in the U.S., U.K. 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 oligopoly 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 U.S. was downgraded, many institutional investors just changed their guidelines. The Fed confirmed that for banks, Treasury's 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 6/16/2017. 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.
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