What do credit rating downgrades mean?
Filed under: News
Fears of financial catastrophe in the troubled European country have intensified as a result, with David Cameron jetting off to Berlin for crisis talks.
But just how do credit rating agencies decide what score to give? And what impact do downgrades such as this have on a country's economy? Here, we answer these questions and more.
What are credit ratings?
A credit rating evaluates the credit worthiness of a company or a government that issues debt in the form of bonds open to investors, in the opinion of credit ratings agencies such as S&P, Fitch and Moody's.
In other words, it signifies the financial strength of the institution in question, based on its ability to meet its financial commitments.
Credit ratings are not based on mathematical formulas, though. Instead, credit rating agencies evaluate the qualitative and quantitative information at their disposal – including non-public information obtained by their analysts – before making a decision.
Who gives the credit rating agencies the power to decide this?
The big three credit rating agencies - Moody's, S&P and Fitch - control pretty much the entire ratings marketplace between them.
They are funded by the countries and organisations for which they provide ratings. In effect, it is therefore the governments and companies that will be affected by their decisions that endow the agencies with the power to judge them.
How are credit ratings expressed?
The major agencies vary in the way they present their ratings. Moody's, for example, uses letters as well as numbers, while Fitch and S&P use plus and minus signs.
They all rate strength in a similar way, however, with an A-rated government or company deemed stronger and less risky than a B or C-rated institution.
It is also safe to assume that a triple letter rating, such as AAA (the highest possible rating) or BBB, is better than a double letter rating, such as AA or BB.
Why are credit ratings important?
Individuals and institutional investors who purchase the bonds issued by companies and governments use credit ratings to determine how likely the bond obligations are to be paid. Those rated AAA can charge more than those rated BBB as a result.
The rating awarded to a country by the major agencies is also important because it affects stock market sentiment.
Spain's rating being downgraded, for example, will make international investors more wary about investing in Spanish companies, meaning that their share prices are likely to fall.
The country will probably sink further into recession as a result, while the political power the Spanish government can wield on the world stage will also be diminished.