In 2011, Standard & Poor’s decided to downgrade the U.S. economy’s credit rating from AAA (prime investment grade) to one notch lower at AA+.

The rationale given to this decision has to do with  the political atmosphere that was prevailing in Washington at the time.

“We believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing containing the growth in public spending, especially in entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.”

You can read the full report here.

The second point that they make is: “We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.”

What are Credit Ratings?

Credit rating are one of the tools available to investors to aid in evaluating the attractiveness and risk of bonds in the bond market. They establish the creditworthiness of a lender.

Rating apply to corporations, municipalities, and governments – anyone who sells bonds – and are on a scale of AAA to D typically.

One of the purposes of these credit ratings is to facilitate the smooth flow of capital and to encourage and support investors to invest in the economy and projects that build new hospitals and highways.

The two biggest credit rating providers are Standard & Poor’s and Moody’s, followed shortly by Finch Ratings.

Local rating providers often offer ratings in more geographically specific situations.

What Happened to the U.S.?

The AAA rating that the U.S. had enjoyed for 70 years leading up to the downgrade made U.S. Treasury bonds one of the safest investments available.

This is why people typically refer to bonds being a relatively safe investment. The rating refers to the probability that the U.S. will pay all interest payments and repay the face-value of the bond.

So why might S&P have downgraded the economy while Moody’s didn’t?

This is because S&P uses different criteria to evaluate risk than other firms.

What’s the Criteria?

S&P measures bond risk only on the probability of default. It does not measure on the likely longevity of the default, not in the way that the default will be dealt with.

Moody’s does use these two criteria in addition. It also considers the expected loss on the default, in other words, what the effect of the default will be on the firm.

Credit ratings are not an exact science so each firm will have a slightly different strategy when trying to determine them.

Therefore, any determination about the creditworthiness of a bond is a relatively subjective process, and no guarantee in providing accurate information.

From Standard & Poor’s website:

S&P Global Ratings Disclaimers

The analyses, including ratings, of S&P Global Ratings and its affiliates (together, S&P Global Ratings) are statements of opinion as of the date they are expressed and not statements of fact or recommendations to purchase, hold, or sell any securities or make any investment decisions. S&P Global Ratings assumes no obligation to update any information following publication. Users of ratings or other analyses should not rely on them in making any investment decision. S&P Global Ratings’ opinions and analyses do not address the suitability of any security. S&P Global Ratings does not act as a fiduciary or an investment adviser except where registered as such. While S&P Global Ratings has obtained information from sources it believes to be reliable, it does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Ratings and other opinions may be changed, suspended, or withdrawn at any time.

This explains the different strategies used to evaluate credit worthiness.

Is S&P missing something?

The recovery value is an important element to consider that S&P largely does not. The recovery value is the likelihood of still being able to recover a small portion of the value of the bond after a corporation defaults.

If the government were to default on outstanding bonds, there is a high likelihood that the bonds would still be paid in a matter of days or weeks.

So the reality of a default changes dramatically when you consider the life beyond a default. Of course, everyone evaluates bonds differently, including the credit rating firms.

It is good to have different angles on the bond market, with different interpretive methods, but it is necessary to understand how each firm approaches these ratings.