On Friday afternoon Moody’s, one of the three credit rating agencies, announced that it was downgrading UK sovereign debt one notch from the highest rating of AAA.1 Whilst this is embarrassing for George Osborne, who has staked his reputation on the UK retaining its top rating, there are plenty of reasons for this not to be a disaster.

First, all three rating agencies placed the UK on ‘negative watch’ some time ago, which means they expect the situation to get worse and that a rating cut may be around the corner. As a result, the debt markets were forewarned and the cost of any downgrade was already ‘in the price’, as commentators like to say - i.e. the price of gilts had already changed to reflect the likelihood of a downgrade.

Secondly, the factors which matter in the market for sovereign debt are size, length to maturity and relative credit rating. Although the UK has dropped a notch with Moody’s, it is still on the same level as the United States, so investors looking for a safe haven are hardly likely to desert the UK as a result of the downgrade. Furthermore, although some countries retain the AAA status from all three agencies, the UK has a relatively large amount of debt and a liquid market, meaning that investors can easily buy and sell gilts. Countries with a small amount of debt can be seen as riskier, even if they have a higher rating, because investors may struggle to find buyers if they wish to move their money out. In effect, investors may be willing to trade a perceived increase in credit risk for a reduction in liquidity risk.

The UK also has the comfortable position of having issued debt with long maturity dates - often 20 years or more - and outstanding debt has an average of 14 years to maturity.2 This is longer than almost any other country in the world,3 and means that we are not about to hit a cliff edge which requires us to repay the principal on large amounts of debt.4 Whilst this shouldn’t be used as an excuse to avoid tackling both the debt and the deficit, it does provide some breathing space, and means that there is no immediate need to panic over a ratings downgrade.

The threshold which a rating cut crosses is also important. A fall from AAA to AA1 is not as bad as dropping from A3 to BAA1. In fact, the only threshold which really matters is from BAA3 to BA1 - at this point bonds are no longer considered ‘investment grade’, and some funds (especially pension funds) may be forced to sell at this point, because their terms only allow them to hold investment grade debt.

Finally, remember that Moody’s is one of the agencies which rated securities consisting of sub-prime mortgages as AAA in the run up to the credit crunch. They have demonstrated their incompetence once before - on an enormous scale - not to mention the problems with conflicts of interest.5 We should take what they say with a pinch of salt - even if some investors do use the ratings as a guide to credit risk.

If you want evidence to support the view that the UK is not in an immediate debt crisis, take a look at the gilt auctions section of the UK Debt Management Office, which is responsible for the issuance of UK debt. The figure to concentrate on is the bid to cover ratio, which is an indication of the level of interest for a particular debt issue. Over the past two years, it has never fallen below 1.0, meaning that the issue was fully taken up. In many auctions, the ratio exceeded 2.0, meaning that there were twice as many bids as there was debt available. As with the maturity figures, this shouldn’t be used as an excuse for complacency, but neither should anyone panic.

In summary, there is no reason for anyone (except Osborne) to panic as a result of the downgrade. Don’t pay much attention to Moody’s, and pay even less to Ed Balls when he jumps up and down pointing the finger at Osborne, even though Mr Balls is partly responsible for the mess the country’s finances are in.

Of course, this decision is only unimportant from a business and investment point of view. Politically, it blows a hole in George Osborne’s case for austerity, much of which was pinned on the need for the UK to retain its AAA rating. Whilst Vince Cable has dismissed the cut as ‘largely symbolic’,6 you can expect renewed attacks on the government’s strategy (I’m being generous here and assuming they have one) over the coming weeks.

  1. Moody’s downgrades UK’s government bond rating to Aa1 from Aaa; outlook is now stable

  2. OECD Statistics

  3. Reasons to be cheerful about UK gilts

  4. Sovereign debt acts in a similar way to an interest-only mortgage - i.e. interest is paid throughout the loan period and then the whole amount borrowed is repaid in one lump sum at the end. This is why maturity dates are important.

  5. 2011 Summary Report of Commission Staff’s Examinations of Each Nationally Recognized Statistical Rating Organization (PDF) - from the Securities and Exchange Commission

  6. BBC News, Guardian