Monday 11 July 2016 by FIIG Securities Wave hits lighthouse Opinion

What happens to the bond market if Australia loses its AAA credit rating?

Originally published in The Australian on 9 July 2016

On Thursday, S&P revised the outlook on Australia’s AAA rating to negative from stable

For some years the FIIG research team has pondered the loss of the Australian governments’ treasured AAA credit rating.

One bright colleague suggested that if the government borrowed more to fund critical infrastructure improving productivity by reducing congestion on roads for example, and boosting employment in the process, losing the top tier credit rating would be a reasonable trade off.

On Thursday, S&P revised the outlook on Australia’s AAA rating to negative from stable. This is a warning that the Australian government needs to address some specific issue or there is a one in three chance of a downgrade in the next two years.

S&P is concerned about government spending and increasing debt, and about the delay in getting the budget back to surplus. They are putting whichever party forms government on notice that they must contain spending and increase revenue to maintain the current AAA rating.

If a downgrade eventually occurs, the credit rating agencies will have determined that Australian government bonds are a higher risk place to invest and the typical result being higher costs to borrow via bonds.

Theoretically this should mean that existing government bond prices fall and yields rise. More of our taxes are spent funding the debt and taken away from spending on other important goods and services such as education and healthcare, explaining why it’s important to maintain the AAA rating if possible.

However, in practice this may not be the case.  The UK’s recent loss of its AAA credit rating provides a recent example as to how the markets might react. Standard and Poor’s downgraded the UK after the referendum to exit the EU. S&P cut the rating by two notches to AA and described the vote as “a seminal event” that would “lead to a less predictable stable and effective policy framework in the UK”. Moody’s had already stripped the UK of its ‘AAA’ equivalent rating in 2013.

If an investment is higher risk, investors typically demand a higher return. Logically, interest rates should rise to attract investors. But, that is not what happened.  UK government bond yields went in the opposite direction, falling to record lows.

There is a tsunami of cash out there looking for a home and much of it is directed at government bonds as they are considered ‘safe’ investments. There is so much global uncertainty and volatility that investors are prioritising capital preservation over the lure of a rollercoaster ride to possible high returns. Thus the growing range of negative government bond yields from a mounting list of countries.

This week we witnessed another amazing first. A 50 year Swiss government bond now has a negative interest rate. That number is not a mistake; it is 50 years, not five.

So, there are competing forces at work, lower credit ratings meaning higher risk and theoretically making it more expensive to borrow, competing with a flight to ‘safe’ assets that will preserve capital pushing yields down.

It seems that loss of the AAA status isn’t having the same impact as it did a few years ago.

S&P also moved to change the outlook for major banks and strategically important subsidiaries, which benefit from government support, from stable to negative.  S&P commented, “If the sovereign long term credit rating is downgraded…we would expect to lower our issuer credit ratings on the Australian major banks and senior debt issued by these banks by one notch… and keep our ratings on hybrid and subordinated debt…unchanged because these ratings do not incorporate any uplift from government support”. Regional banks would not be impacted as they do not receive any credit rating uplift for implied support.

Countering the downgrade, Australian major banks are well capitalised on a global scale and current yields on bank bonds higher than equivalent rated international banks. We consider broader market sentiment is more likely to impact yields than a sovereign credit rating downgrade. One of the concerns on our radar is the plight of Italian banks facing bad loan provisions of around EUR24 billion.

Domestic corporate bonds are unlikely to be impacted by a declining sovereign rating in this very low interest rate environment. Our experience is that all types of investors are adding corporate bonds to their portfolios at this point for the higher yields on offer and we continue to watch corporate bond yields decline. The response to the ‘negative watch’ on Thursday was muted.

S&P have kindly signalled to the market the possibility of a credit rating downgrade, its reason for doing so and what it would like to see from the government.

Any future loss of AAA status could incrementally increase cost of funds for the government and the major banks. But, assuming market conditions are similar and the very low interest rate environment persists, momentum in favour of the asset class is likely to outweigh the impact of a downgrade.

See the link below for further comments on Australia's AAA credit rating outlook change.