What does the negative outlook on the US debt really mean?

After the market closed on Friday, November 10th, the credit rating agency Moody’s revised the United States’ debt outlook from stable to negative.

This suggests the possibility of the country losing its perfect credit rating in the upcoming review, typically conducted within 30 to 90 days. Moody’s has maintained the AAA rating for the United States since 1917.

However, Standard and Poor’s downgraded the country’s credit rating in 2011, and Fitch Ratings followed suit last August.

According to Moody’s, the nation faces a very large deficit and lacks an efficient fiscal policy, making it challenging to reduce government spending or boost revenues significantly.

Significant political tensions further complicate the management of the budget and the debt ceiling. In the event of another downgrade by the credit agency, American debt would not be considered the safest, very likely leading to an increase in US yields, which would, in turn, impact various types of US debt (as well as all American financial markets by extension).

While the market witnessed a harsh and dramatic reaction in 2011 during the United States’ first credit rating downgrade, experts anticipate that the situation might unfold differently this time. However, increasing US yields typically exert downward pressure on the markets.

Additionally, any potential default by the American government on its debts would be catastrophic and have a huge impact on the reputation of the country and the financial markets.

What are ratings agencies?

Credit rating agencies such as Moody’s Investors Service, Fitch Ratings, and S&P Global Ratings are private companies paid to assess the solvency of companies and governments.

They determine a borrower’s creditworthiness by assigning a credit rating and outlook, providing investors with a way of evaluating the risk of non-repayment for the analyzed companies or governments.

How do credit rating agencies decide to upgrade or downgrade a country’s or a company’s rating?

As the primary objective of credit rating agencies is to provide a comprehensive assessment of the risk associated with non-repayment by issuers, they need to conduct an exhaustive analysis of data, which can come from various sources.

On the quantitative front, they delve into financial aspects such as balance sheets, income statements, and cash flows for companies to determine their overall financial performance and health.

In the case of countries, the analysis centers around indicators like the debt-to-GDP ratio, fiscal policy, and the history of debt payment.

They also consider more qualitative information, including a company’s strategy, competitive advantage, industry dynamics, operational efficiency, and management practices.

For countries, they evaluate factors like political and social stability, the strength of the legal and regulatory framework, environmental policies, infrastructure quality, competitiveness, revenue-raising ability, quality of financial management, and foreign exchange reserves.

Macroeconomic data also plays a role in this assessment process. Agencies consider market and sector-specific conditions for companies, while indicators such as a country’s growth prospects, inflation rate, trade balance, and interest rates are crucial for evaluating the economic health of nations.

Why do their credit rates and decisions to upgrade or downgrade matter?

Credit ratings play a pivotal role in shaping perceptions of a company’s or a country’s financial stability.

When credit rating agencies adjust a credit rating or its associated outlook, it directly affects the entity’s ability to secure credit in financial markets.

Moreover, it has a direct influence on the costs associated with that credit, thereby impacting the financial landscape of the company or country.

The ramifications of these credit rating actions can be quite extensive. An improvement in a credit rating can lead to more favorable financing conditions in the markets, positively affecting the overall finances of the company or country.

Conversely, a downgrade may result in more expensive financing conditions, as investors might demand higher interest rates to compensate for increased risk. This, in turn, often leads to higher debt costs and places additional strain on public finances or puts pressure on companies facing increased financial burdens.

For investors, any change in a credit rating or outlook can have an impact on their portfolios, as these ratings serve as a guiding factor in their investment decisions.

Entities with higher ratings are generally perceived as safer investments, offering stability, while those with lower ratings may present higher potential returns but come with an elevated level of risk.

Credit rating changes can also impact market sentiment. Upgrades can boost confidence and thus attract more investors, while downgrades may lead to sell-offs as investors re-evaluate the risk associated with the entity.

Institutional investors, such as pension funds, mutual funds, brokers, and insurance companies play an important role in determining the flow of capital within financial markets. Therefore, their investment decisions are closely monitored by market participants, as they can signal broader trends or shifts in sentiment.

Professional investors need to keep a certain amount of money invested in high-quality bonds, as mandated by regulatory requirements (the famous “investment-grade” requirements as opposed to riskier “junk bonds”).

So credit rating downgrades can have an impact on institutional investors’ portfolios, as it might require them to to adjust their holdings to maintain compliance with regulatory guidelines, which can influence the value of your holdings.