The recent downgrade of French, Italian and other European countries debt, including the United States some months ago, upsets investors and sends markets down. But why the big hubbub when a rating agency such as S&P, Fitch or Moody’s lowers the rating from a AAA rating to AA+ (or the equivalent)? The bond still stays at investment grade meaning that it has nearly zero chance to default but the fact still remains that when a credit rating agency downgrades debt the market reacts, and violently in some cases.
The bond credit rating system is different for each of the three major agencies; Fitch, Standard & Poor (S&P), and Moody. Fitch and S&P have adopted the same figures to rate bond: AAA for the gold standard or prime rating of bonds, below that is AA+, then AA, AA-, A+,A,A-, BBB+, BBB, Etc. all the way down to D. Moody has a similar rating system with Aaa being the prime credit rating followed by Aa1, Aa2, Aa3, A1, A2, A3, Baa1, etc. all the way down to C followed by defaulting bonds. These ratings are only for longer term bonds meaning over one year.
Bond’s credit ratings are a reflection of the rating agencies expertise and belief of whether or not a bond will default meaning that the people who bought the debt will lose their investment. The higher the rating the less likely a bond will default. For the longest time the United States issued debt was the gold standard of bonds with a AAA rating. This makes buying treasury bonds a safe investment meaning that you will receive a return on your investment with zero chance of default. Bonds with high credit ratings are able to offer lower interest rates because of the fact that they offer stability to investors. Bonds with credit ratings of BBB+ or Baa1 are called “Investment Grade” bonds meaning that they are a stabilizing force in a portfolio where the interest rates will tend to stay fairly constant and there is a very good, almost guaranteed, chance on a return on your investment. Bonds with a credit rating below BBB+ or Baa1 are called high yield or “junk” bonds. These bonds are popular with traders because of the fact that their interest rates and therefore the price on the bonds fluctuates regularly making speculation popular and arbitrage possible.
A bond’s price and interest rate work in an inverted fashion meaning that if the interest rate goes down the price of the bond goes up and vice versa. With an investment grade bond the prices are higher and interest rates lower because of the fact that investors want a stable force in their portfolio. In junk bonds the interest rates are higher and prices lower because the issuer of the debt has to entice investors to take a chance on their bond.
With several European countries receiving credit rating cuts to their bonds this means that they will have to lower the prices of their bonds and increase interest rates because investors do not want to pay a AAA price for a AA+ rated bond. This also troubles previous owners of the country’s bonds because they are taking a cut in the price that they can now resell the bond for. This upsets the markets because of the fact that it means economies are growing unstable which means businesses and investors want cash on hand so they pull money out of equity markets like the Dow or NASDAQ. These downgrades present new opportunities in the bond markets now because speculators can buy bonds on the cheap and sell them at a premium should the bond regain a higher rating. If Greece somehow ends up not defaulting on their debt by March the owners of their debt should be rewarded with decently high returns on their investments which explains why a lot of hedge funds are buying up Greek debt.
I hope this has given a little clarity into the bond rating system and bond market.