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