What a U.S. Credit Rating Downgrade Means

Moody's has downgraded the US's credit rating from the best (Aaa) to second-best (Aa1), sending the markets into a buzz. But what does it mean to downgrade a credit rating?

All bonds have a property called credit risk. This is the probability that the seller of the bond will default on their debt and not pay it back in full or on time. This goes for all kinds of debt, whether it's a corporate bond, a mortgage, or credit card debt.

The quantification of credit risk is important for pricing financial instruments. The reason that the interest rate on a credit card is much higher than a mortgage is because lenders know that people are much more likely to default on credit card debt than mortgages, and want to be compensated more for taking on that risk. (A mortgage also has a lower interest rate because it's secured debt, but I'll ignore that for the purposes of this explanation)

For corporate and sovereign (fancy word for national) bonds, this risk is expressed through credit ratings. Ratings agencies like Moody's, S&P, and Fitch look through financial statements, the macroeconomic outlook, and historical data to determine the credit risk of a debt issuer. They will then issue ratings based on their assessment, which can then be directly translated into an equivalent hazard rate (probability of default over a given period) for the purpose of pricing credit derivatives.

This downgrade reflects Moody's belief that, as a result of mounting US debt, they have increased in credit risk, a belief shared by S&P and Fitch, who have both already downgraded the US in a similar way.

A Saturday surprise like this will no doubt impact markets soon. Previous downgrades have led to yield spikes and market rallies. The 10-year yield is already going up, and we'll see how the markets will look on Monday.

What do you think? Does the US deserve this downgrade?

From Bloomberg: https://lnkd.in/e9yQ9u2E