Tuesday, November 22, 2011

Debt, Yields, and Ratings Agencies

With the failure of the Super Committee in terms of coming up with a deficit reduction proposal, there's some talk as to whether this will lead to a downgrade of the credit rating of the US.  Do investors rely on credit ratings agencies to make decisions as to where to invest?  The experience of the US and Europe help to provide an answer to that question.  When S&P downgraded the US in August, some feared that this would cause investors to shy away from US bonds, leading to a spike in interest rates, but it didn't happen.  Active participants in financial markets, particularly the bond market, do their research before investing.  Investors know that the US budget deficit is extremely high and the national debt is rising at an unsustainable rate.  The downgrade by S&P didn't contain any information that wasn't already widely understood and thus had little effect.

Similarly, the credit ratings of France and Ireland have not been changed recently, but yields on each nation's bonds have changed significantly.  In the case of Ireland, yields have declined quite a bit since the summer, indicating that financial markets are less pessimistic about Ireland's debt situation.  Meanwhile, yields on French bonds have risen considerably, reflecting increased concern about French debt (despite France still having a AAA credit rating).  Clearly, investors make decisions based on their research and don't wait for credit rating agencies to act.

Changes in credit ratings have an impact when they reveal new information about a country's or company's financial condition.  However, the more important issue is the bond market's perception as to the sustainability of a country's debt situation.  Though the US doesn't seem to be at risk in the near term, the debt situation becomes more unsustainable the longer it waits to deal with its deficit.