Gold News

What Credit Ratings Don't Tell You

Default is not the only risk bond investors should worry about...

WE HAVE seen credit ratings agencies come under considerable fire for not being proactive enough in recognizing bad sovereign risks, writes David Howden for the Cobden Centre.

Even if the ratings agencies were a little quicker with the downgrades, the result would not be significantly different for investors. This is because there are two paths to default.

Credit ratings agencies exist to measure one thing – the risk that an entity will explicitly default on its obligations. In this regard, ratings agencies by-and-large do fairly well. What they do not do well (nor is it their job), is to assess the risk of the other default, the one by inflation.

Charles Goodhart argues that we can see the distinction if we compare the plights of two countries. England has high debt to GDP levels, yet has retained its rating through the recent downward revisions. France, by comparison, has lower debt levels and was recently downgraded. What gives?

Some would argue, as the ratings agencies do, that France is threatened because she cannot inflate her worries away. The Euro blocks this option, as Paris must succumb to Frankfurt on monetary affairs. England faces no such constraint, or at least, not an insurmountable one. The Bank of England might be nominally independent from Her Majesty's Government. Yet what the crown gives it can take away. The BoE can be a direct policy arm of parliament if need be. When faced with insolvency, such a course of action is foreseeable.

Inflation (both measured and expected) is already higher in the UK than in France. While the investor buying French debt worries about a small chance at not getting his money back, the buyer of British bonds faces the fact that the bond's nominal value is continually eroded at a faster rate than his French counterpart.

For the investor, it makes no difference which default occurs. Whether explicitly at a moment through insolvency or slowly through inflation, the effect is the same. Long drawn out tortures can be just as effective as swift death sentences (sometimes more so).

Investors fixated on credit ratings are cognizant of only half the story. Given this, one wonders if the official ratings mean anything at all.

Take the United States, for example. Its recent downgrade brought into question Washington's ability to pay off its national debt (among other obligations). But that was just making explicit what was already implicit for decades. As inflation ate away at the nominal value of the debt, the country was slowly defaulting by another means.

Some may look at the low interest rates on US Treasuries right now, and argue that the risk of default is low. These investors would likely be correct. One could also argue that interest rates are low because the Fed has been purchasing large quantities of them, and without this intervention rates would signal a much different story. This story is also likely correct. But the latter story is just removing the explicit default risk from the Treasury and giving it to the Fed. The Fed will just buy more bonds from the Treasury to finance the payoff of the existing ones if the threat of default nears. This amounts to default not at the hands of Treasury, not explicitly anyhow. This becomes a Fed-orchestrated default, through the process of inflation.

Rating agencies do investors a great favor by pointing out the explicit default risk of different debt securities. Investors would do well to recognize the limited relevance of these ratings, especially in light of the continual implicit defaults we are exposed to through inflation.

Buying Gold or Silver Bullion? Get investment grade bullion at the lowest price possible with BullionVault... 

Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

Cobden Centre articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

Follow Us

Facebook Youtube Twitter LinkedIn



Market Fundamentals