How is a country's credit rated?

Fitch Ratings, one of the world's foremost credit rating agencies, downgraded the USA's credit rating a few days back, from AAA to AA+ (see here). Fitch said fiscal deterioration, rising government debt, and poor governance were the key reasons behind the decision for the downgrade. And while most experts are saying that this downgrade was not a big deal, it is important to understand how this credit rating system works.

There are a few companies that assess the creditworthiness of companies, fixed-income securities and yes, countries or governments. Typically, at the request of the government, these companies evaluate the political and economic environment in these countries to find out the kind of risk an investor is taking when they invest in these countries.

Countries typically want their credit rating evaluated because when they want to raise funds in order to do developmental or managerial work, having a good rating makes finding lenders easier. Many countries seek ratings from the biggest credit rating agencies to encourage confidence among existing and potential investors. Standard & Poor's, Moody's, and Fitch Ratings are the three most well-known companies in the sector.

As with all securities, the greater the risk, the greater the returns. But the risk is of all the money getting lost here, since if the worst-case scenario unfolds, the country would have defaulted and wouldn’t be able to pay its obligations.

If a country’s credit rating is upgraded, it means that they are in a better position to pay back any loans they might have taken. Conversely, if this rating is downgraded, it means there is increased risk in terms of repayment. And while the USA being downgraded from AAA to AA+ might not mean too much, a country being downgraded let’s say, from BB to CC due to unrest in the country, would make investors nervous.

The Fitch scale goes like this: AAA, AA, A, BBB, BB, B, CCC, CC, C, RD and D, with an additional + or - for AA to CCC levels indicating differences in the probability of default or recovery. The symbols used by other credit rating agencies are different, but they obviously lie on similar lines.

You may have seen this in the movie “The Big Short”, but these agencies follow an "issuer pays" model, in which these governments/countries pay the agency to rate them. This raises a potential conflict of interest for these companies.

So what do you think? Should the bond investors pay for the credit ratings to get a more unbiased rating or is the current system good as it is? Anyway, if you enjoyed this article, you can read more from me here. And do let me know if you want a specific topic covered. Subscribe for free to receive more posts like this every day!