What’s Really in a AAA Credit Rating?

If you’ve ever tried to borrow money from the bank, you’ll be familiar with the term credit score. Lenders use this score to access the likelihood of you paying back the money you borrowed. But how are these credit scores determined?

The credit bureaus that issue these scores take various factors into account. The primary factors used are credit payment history, current debts, time length of credit history, credit type mix and frequency of applications for new credit.

A large amount of debt, or a bad repayment history, could restrict you from further borrowings. So it’s understandable that many individuals fear having a bad credit score. And it’s not just individuals who live in fear of not being able to borrow money. Companies and nations also share the same desire to keep their credit ratings as high as possible.

However, when it comes to companies and nations, the ratings system is slightly different. Instead of numbers, companies and nations are ranked by letters. The highest (safest) credit rating a company or nation can have is AAA; the lowest (riskiest) is CC.

Of course, different credit ratings agencies use different symbols to rate credit. For example, the above example is how Standard & Poor’s (S&P) rate credit. But Moody’s will use the symbol ‘Aaa’ as the safest rating, and C as the riskiest rating.

Australia’s Credit Rating

Since 1986, Australia has had held the highest (safest) credit rating. However, just yesterday, it was S&P that placed Australia on credit watch. Along with credit ratings, these agencies also grade whether a nation position is negative, stable or positive.

Credit watch means that Australia is now on a negative outlook. This means it is now at risk of being downgraded from AAA to AA. S&P said the credit watch was issued because of the ‘growing fiscal vulnerabilities.’ It continues: ‘The negative outlook on Australia reflects our view that prospects for improvements in budgetary performance have weakened following the recent election outcome.

The uncertainty of the election has also played a role in S&P’s decision. A majority government is very important in this situation. In order to pass revenue and expenditure bills, they need to go through both houses.

However, if there is no majority government, these bills could be delayed or blocked altogether. This could raise debt levels over a forecasted period. And until S&P sees more budget saving measures legislated, Australia will remain on credit watch.

There’s a one in three chance that Australia’s credit rating could lower within the next two years. But will this adversely affect our country in any noticeable way?

What a Lower Credit Rating Means for Australia

Banks might not lend to individuals because of their credit score. However, I don’t see Australia — with an AA credit rating — struggling to find lenders. Places like Japan and parts of Europe are riddled with debt. Yet they have credit ratings of A+ and AA. They also have no trouble when they want to borrow from banks or other nations.

However, the interest they would pay on those loans is higher. And it’s all because of risk and return. Nations with low credit ratings are deemed risky. So, to compensate the lender, they charge a higher rate of interest.

Fears surrounding a downgrade are not because of Australia’s ability to borrow. But they revolve around interest repayment concerns. Federal Treasurer Scott Morrison said the credit outlook is sobering.

The Treasurer said it would ‘not be responsible’ to take policy decisions that could increase the deficit. I suspect his comments are targeted at playing to the sentiments of a particular group of Australians.

Either way, I see this as a non-issue. Remaining on credit watch or getting downgraded will just be more news to create pessimism in the market. When it really comes down to it, investors could benefit the most. Why?

Recently we have had many economic distributions. All of which have made our markets volatile. And that’s exactly what Australian investors can profit off. Selling down stocks on sentiment alone just makes those stocks cheaper for savvy investors.

So stay prepared and look for opportunities. We are living in interesting times, and almost anything will send pessimistic investors fleeing the market.

Härje Ronngard,

Junior Analyst, Money Morning

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