Sovereign Debt Downgrades: The Trend Continues

On September 19, Standard & Poor’s downgraded Italy’s
sovereign debt rating by one notch to A from A+. The downgrade follows other
recent downgrades of developed countries, including Portugal, Ireland, Greece,
Spain, and the United States.

The reasons given for the Italian downgrade are similar to
those behind the other downgrades: mounting government deficits and weakening
growth prospects. More specifically, S&P announced that “the downgrade
reflects our view of Italy’s weakening economic growth prospects and our view
that Italy’s fragile governing coalition and policy differences within parliament
will likely continue to limit the government’s ability to respond decisively to
the challenging domestic and external macroeconomic environment.”

Rating agencies apply a host of quantitative and qualitative
factors in assessing sovereign credit quality. Unlike corporate debt ratings,
political risk, fiscal and monetary flexibility, and access to external funding
are all factors unique to sovereign ratings. Corporate ratings tend to stick
with a more quantitative approach.

Selected Sovereign Ratings (as of September 23, 2011)

 

Country Current Rating Date of Most Recent
Change
United Kingdom AAA 1978
France AAA 1975
Germany AAA 1983
United States AA+ August 2011, down from AAA
Spain AA April 2010, down from AA+
Italy A September 2011, down from A+
Ireland BBB+ April 2011, down from A-
Portugal BBB- March 2011, down from BBB
Greece CC July 2011, down from CCC

 

For bondholders, the immediate effect of the downgrades is to
increase rates and lower prices on new issues by the downgraded entities. A
downgrade may also imply a drop in secondary market prices for existing issues,
since the downgrade implies greater risk of default. However, this is not
always the case, as recent experience with the U.S. downgrade has shown.
Following S&P’s August 5 U.S. downgrade from AAA to AA+, prices on U.S.
Treasuries actually increased, as investors worldwide turned from stocks to the
safe haven of U.S. Treasuries.

Perhaps the most important factors that bondholders should
consider in a downgrade are level and the trend. In the case of the United
States, Spain, and Italy, all three countries still have ratings of A or higher
— hardly default territory. Greece, on the other hand, is teetering on the
edge of default, while Portugal and Ireland are both considered speculative
grade. The trend is also important, as multiple downgrades, such as those seen
by Greece, tell a story of their own.

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© 2011 McGraw-Hill
Financial Communications. All rights reserved.

October 2011 — This column is provided through the
Financial Planning Association, the membership organization for the financial
planning community, and is brought to you by Ronald J VanSurksum, CFP® , a
local member of FPA.

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