A response to Moody’s downgraded UK Government bond rating

As many will already know, Moody's ‘downgraded the domestic- and foreign-currency Government bond ratings of the United Kingdom by one notch to Aa1 from Aaa.’ on February 22nd 2013. You will have seen much press comment on this issue and its potential consequences.

The purpose of this blog is to consider this issue further. The reality is that there is very little intrinsic value in this news; both the downgrade and the reasons for the downgrade were widely anticipated. It should be noted that the judgements of the ratings agencies have only a limited influence on the relative attractiveness of G7 Government bonds.

The UK’s new, lower credit rating

The UK has enjoyed the highest possible credit rating from Moody’s since March 1978. A little over a year ago, on 13 February 2012, Moody’s warned of a potential downgrade when it altered the outlook from ‘stable’ to ‘negative’.

We are not alone, and now, Britain joins France and the US, leaving just Canada and Germany among the G7 with an Aaa rating.

An Aa1 credit rating is the second notch in a rung of 21 possible ratings (see table 1), which are detailed below for reference and consideration:

Table 1. Moody’s Investor Services

Rating	Description
Aaa	The highest quality and lowest credit risk
Aa1, Aa2, Aa3	Rated as high quality and very low credit risk
A1, A2, A3	Rated as upper-medium grade and low credit risk
Baa1, Baa2, Baa3	Rated as medium grade, with some speculative elements and moderate credit risk
Ba1, Ba2, Ba3	Judged to have speculative elements and a significant credit risk
B1, B2, B3	Judged as being speculative and a high credit risk
Caa1, Caa2, Caa3	Rated as poor quality and very high credit risk
Ca	Highly speculative, near or in default, some possibility of recovering principal and interest
C	Lowest quality, usually in default, low likelihood of recovering principal and interest

Moody’s justifies the UK’s standing at this high rating as follows:

‘...the UK's creditworthiness remains extremely high, rated at Aa1, because of the country's significant credit strengths. These include (i) a highly competitive, well-diversified economy; (ii) a strong track record of fiscal consolidation and a robust institutional structure; and (iii) a favourable debt structure, with supportive domestic demand for Government debt, the longest average maturity structure (15 years) among all highly rated sovereigns globally and the resulting reduced interest rate risk on UK debt.’

In applying a ‘stable outlook’, Moody’s are not anticipating any change to the current rating in the next 12 to 18 months.

‘The stable outlook on the UK's Aa1 sovereign rating reflects Moody's expectation that a combination of political will and medium-term fundamental underlying economic strengths will, in time, allow the Government to implement its fiscal consolidation plan and reverse the UK's debt trajectory. Moreover, although the UK's economy has considerable risk exposure through trade and financial linkages to a potential escalation in the euro area sovereign debt crisis, its contagion risk is mitigated by the flexibility afforded by the UK's independent monetary policy framework and sterling's global reserve currency status.’

You might wonder then, why it is that Moody’s has downgraded UK Government debt...

Reasons for the downgrade

To consider this further, Moody’s suggest that there are three interrelated ‘drivers’ for its actions.

1. The continuing weakness in the UK's medium-term growth outlook, with a period of sluggish growth which Moody's now expects will extend into the second half of the decade;

2. The challenges that subdued medium-term growth prospects pose to the Government's fiscal consolidation programme, which will now extend well into the next parliament;

3. And, as a consequence of the UK's high and rising debt burden, deterioration in the shock-absorption capacity of the Government's balance sheet, which is unlikely to reverse before 2016.’

In short, the UK appears to be stuck in a protracted and unusually slow period of recovery. This has suppressed tax receipts; just as it inflates Government spending and all the while it remains in recovery it also remains highly vulnerable to any kind of external shock.

What could the impact be?

It is not possible to say with any certainty what the impact of this downgrade will be, but... as I wrote in my opening remarks there is very little news contained in Moody’s announcement. It was increasingly odd that the UK maintained the very highest rating when the US, which has made far greater progress toward a sustainable recovery, lost its Standard & Poor’s AAA rating 18 months ago.

There is some sympathy for Martin Wolf’s view, expressed in his Financial Times column on 23 February, which says:

‘The judgment of the ratings agencies adds next to nothing to understanding of the economic condition of such a well-known issuer... Armies of official and private economists understand the underlying data and closely follow developments. In this crowd of commentators, the rating agencies are just another voice... At most, Moody’s has reminded the world of what it knows... Partly for this reason, the downgrade is unlikely to damage the UK gilt market.’

The yield on the 10-year gilt was 32 basis points (0.32%) more than the equivalent German bond this time last year when Moody’s applied a ‘negative’ outlook for the UK. That ‘spread’ subsequently fell to 13 basis points in August last year, in defiance of Moody’s judgement, before rising steadily to a current spread of 55 basis points. I’ll leave it to you to decide if Moody’s are responding to the market’s judgement or if the markets are responding to Moody’s judgement.

Summary
Gilt yields have risen, of late, in lock-step with equity markets just as German, Japanese and US Government bond yields have. This will remain the dominant factor affecting gilt yields.

Moody’s downgrade follows a growing perception that the outlook for Britain’s fiscal position has not progressed. Underlying this are serious challenges for policymakers in the UK. Thus far, the Chancellor of the Exchequer has pressed ahead with austerity measures that have, by now, proven unwise in voracity at the same time as placing too much faith in the ability of the Governor of the Bank of England to support the economy single-handedly. A fall in sterling’s trade-weighted exchange rate is already underway. Perhaps the downgrade from Moody’s will add just a little impetus to sterling’s decline.

Past performance is not a guarantee of future performance. Fund values can fall as well as rise and are not guaranteed.

At Chapters Financial, we have been planning client’s investment planning for many years, offering high quality independent financial advice. Because each consumer is different, as is their financial planning needs, no individual advice has been provided in this Blog.

Keith G Churchouse,
Chartered Financial Planner, Director,
Chapters Financial Limited Chapters Financial Limited is Authorised and Regulated by the Financial Services Authority. Number 402899

Long Term Care, Care Costs and Inheritance Tax

I am not sure I have ever seen two high-profile financial planning issues linked so closely by Government before, namely that of Inheritance Tax and care costs for Long Term Care. The recently commissioned Dilnot Report has done much to correctly move the issue of care costs forward.

Both topics are emotive subjects for both families and those in their older ages. They will generate much text over the next few months. The new plans (subject to confirmation and detail) is to cap long term care costs at £75,000 with assessment for this cap starting at a new level of £123,000. With care costs for many running at around £1,000 per week, as an example, you can soon work out that with £52,000 per annum being spent on care costs, it is easy for estate values to fall quickly. Ironically, this has the 'advantage' of reducing future Inheritance Tax liabilities.

The 'generosity' of this change offered by the Government will not be without expense. We are all aware that they have no money and this change will need to be afforded. This is planned to be achieved by freezing Inheritance Tax (IHT) levels until 2019. In George Osborn's Autumn Statement at the end of 2012, the current Inheritance Tax nil rate band allowance for an individual of £325,000 was going to increase to £329,000 from tax year start 2015/2016. This plan has now clearly changed to accommodate this new planning.

The devil may well be in the detail and I am sure there may be a few more changes before these (apparently) now linked allowances are finalised.

No individual advice has been provided during the course of this blog. Both Long Term Care and Inheritance Tax should be planned for carefully and if you would like to receive individual advice for your circumstances, then please contact the team at Chapters Financial Limited on 01483 578800

Keith Churchouse, FPFS
Director, Chapters Financial Limited, Guildford, Surrey

Chapters Financial Limited is authorised and regulated by the Financial Services Authority, number 402899.

Sick Pay Cover – Do you have enough?

I recently completed a financial plan for a director of a successful local company. Amongst the usual planning for pensions and life cover, I also wanted to address a much overlooked (and vital) area, which is the protection of income in the event of inability to work due to ill health. In this case, the topic was especially relevant because the business was young and very much reliant on its director to drive sales. He was clearly good at this because of the trajectory of profits achieved so far.

With no cover elsewhere, other than capital achieved from sales within the company which would deplete quickly without its sales 'driver', this was an area of exposure that once identified, the director wanted to address promptly.

Far too few people consider the impacts on their household finances in the event of them being unable to work due to ill health. Statutory Sick Pay (SSP) only pays for a maximum of 28 weeks at a level of £85.85 gross per week (2012/13) paid by the employer with income tax and National Insurance to be deducted.

In this blog, I wanted to look at the factors that can affect the final monthly premiums offered on Income Protection Policies, all of which are subject to medical underwriting.

The obvious factors are existing health condition, age and if the applicant is a smoker (which would see premiums lift significantly).

The other main factors which now influence premium levels are as follows:

G-Day
The recent EU ruling on the equalisation of rates between men and women has seen the most dramatic increases on male applicants for income protection policies. In some cases the increase has been as high as 40-50% increase for a male applicant in comparison to pre-G-Day (Gender Equalisation day of 21st December 2012), although a more typical increase could be around 25-30%. Conversely, female applicants should see a reduction of their premium in comparison to their premiums pre-G-Day, although I don’t believe it will be as large a discount as the increases seen for males.

End date / Term
As noted above, the maximum term which SSP pays is 28 weeks, however most Income Protection Plans, also known as Permanent Health Insurance (PHI) policies, can be set with a cover period up until the applicants 65th Birthday, possibly even longer depending upon the insurer. Obviously the longer the cover period (especially with the policy term into the advanced age range of 55 to 65) will increase the premium accordingly, however this longer period can be invaluable when planning your protection needs because it allows for some income provision beyond the Statutory Sick Pay (or even an employers’ own sick pay arrangements).

Inflation uplift / Escalation
At the outset of the insurance policy you can select whether the cover amount will stay level (cheaper premiums) or escalate / increase (usually in line with inflation as an example). Escalation will increase the monthly premium, but if the policy is to be in force for many years (for example a 30 year term) then at the point of claim the escalation of benefit could prove very worthwhile if the claim is towards the end of the policy term.

Waiting Period
This is sometimes referred to as a deferral period and is the length of time the claimant has to be unable to work due to ill health before a claim will be paid. The longer you set the deferral period the cheaper the premiums will be, however planning should be taken to ensure that sufficient other funds / income are available to provide for loss of income during the selected waiting period. Examples of waiting periods might be 4, 8, 13, 26 or even 52 weeks.

Calculation of amount of cover (maximum)
One of the key drivers for insurance premium costs is obviously how much cover is required and, therefore, the amount the insurer will have to pay in the event of a claim. In my opinion, the key minimum cover should be the amount the individual pays towards household costs on a monthly basis. However, in most cases this is not the ideal and careful consideration should be taken in planning the appropriate level of cover.

Dividend v Salary
This is a very important issue, especially considering my example case mentioned above. This is because many business owners / directors pay themselves nominal salary and higher dividend amounts for tax, and potentially cash-flow, purposes. Many insurers may not include the dividends in their calculation of a claimants income, so the desired amount of cover may not be available, or even paid, in the event of a claim. Some insurers may apply an increase in premium to reflect that they will include dividends. Careful attention of the terms and conditions of the income calculation allowed must be considered before starting the policy.

Guaranteed / Reviewable Premiums
The final major point which could affect the premium illustrated is whether the premiums are guaranteed (i.e. they will not change, apart from escalation if chosen, during the term of the policy) or reviewable. Reviewable premiums allow the insurer to calculate premiums collected against claims amounts paid and if they believe that there is a discrepancy then they can amend the premiums accordingly. This review tends not to be done on an individual basis but rather on a demographic basis for the insurers “risk book”. Guaranteed premiums tend to be slightly more costly at outset, but at least you know what you will be paying during the term of the policy.

Individual or Employer pays the premium
Generally speaking, insurers have an understanding that all income protection policies which an individual can hold will pay a combined maximum of 50% of a claimants gross annual earned income. This will normally be paid on a tax-free basis if the individual pays the premium. If the premium is to be paid for by the employer, then the maximum available is usually 65-75% of the claimants gross income paid on a taxable basis.

As you would expect, each element noted above is likely to have an effect on the final premium offered. Being independent financial advisers (IFA's) we have the ability to use the whole market to search out competitive providers in most circumstances.

No individual advice has been provided during the course of this blog. Protection in the event of either death or ill health should be planned for carefully and if you would like to receive individual advice on this subject, then please contact the team at Chapters Financial Limited on 01483 578800

Simon Hewitt BSc (Hons) Dip PFS
Financial Planner

Chapters Financial Limited 
Chapters Financial Limited is authorised and regulated by the Financial Services Authority, number 402899.