The big credit headline this week in the sterling bond world is that the UK gilt market has been put under review by one of the top three rating agencies Moody’s, for a downgrade from AAA to AA+. As bond investors in gilts and not politicians who love making sound bites, what does it really mean for the credit worthiness of gilts?
According to Moody’s European issuer-weighted default rate data since 1985, the probability of a AA rated default over the next 10 years versus that of a AAA is 0.55% vs 0.04% (Moody’s only publish data for ratings bands, but a AA+ default probability would be even lower). So hardly a big change despite the headline. This is due to the logarithmic nature of rating scales. At the top end the agencies try to fine tune to create a difference between strong sound investment grade credits, but that is harder to do at the bottom of the scale, as by definition the riskier speculative grade credits have less control over their potential default.
Given only one of the three main rating agencies has taken this negative view on the UK, if we weight their views appropriately then using the increase in default probability from Moody’s and reducing it by two thirds to take account of an average rating from the three agencies, the increase in probability of default would be just 0.17%. This obviously assumes that the rating downgrade occurs and we have used the more aggressive default rate data embedded in a AA category, rather than the AA+ it would go to.
So headline news, but the risk of default on gilts would remain to all intents and purposes unchanged. The most interesting part of the rating actions from Monday is not UK centric, but euro zone centric, where downgrades for example of that of Spain from A1 to A3 do result in a more noticeable increase in the probability of default using rating agency methodology.