After S&P changed the outlook to negative from stable on Australia, NSW, Victoria and ACT’s AAA rating and the four domestic majors’ AA- rating there were factually incorrect headlines and articles all over the place
I can’t tell you how frustrated I get to see this terminology getting misinterpreted – you should see my sock drawer! Is it any wonder that some investors and the general public are confused about credit ratings?
These are some of the misleading headlines:
“S&P puts AAA on downgrade watch”
“Australia's AAA credit rating put on negative watch”
“Australian Government, major bank credit ratings put on negative watch by Standard & Poor's”
“Here's what economists are saying about S&P placing Australia's credit rating on watch negative”
“S&P places Australian major banks on negative watch as well”
“S&P puts Australian credit rating on negative watch”
In fairness and to give credit where credit is due (no pun intended), there were some headlines that got the details correct:
“Federal election 2016: Standard and Poor's puts Australia's AAA credit rating on negative outlook” smh
“Standard and Poor's lowers Australia's AAA rating outlook” The Australian
“Australia Dealt AAA Blow as S&P Cuts Outlook on Fiscal Gridlock” Bloomberg
Where you able to spot the errors? There is a big difference between a negative outlook and a negative watch.
What did S&P actually do?
On Thursday, S&P revising the rating outlook on Australia to negative from stable, it affirmed the credit rating at AAA. The rationale behind the move was:
“The negative outlook on Australia reflects our view that without the implementation of more forceful fiscal policy decisions, material government budget deficits may persist for several years with little improvement. Ongoing budget deficits may become incompatible with Australia's high level of external indebtedness and therefore inconsistent with a 'AAA' rating.”
On Thursday, S&P revising the rating outlook on the State governments of NSW, Victoria and ACT:
“…it had revised the rating outlooks to negative from stable, on the State of New South Wales (NSW) and the New South Wales Treasury Corp.; the State of Victoria (Victoria) and the Treasury Corp. of Victoria; and the Australian Capital Territory (ACT). At the same time, we affirmed the 'AAA/A-1+' ratings on these five entities.”
The rationale behind the move was:
“We cap our long term rating, and hence the outlook, on NSW at the level of the long-term rating on Australia as we do not consider that NSW meets the conditions for rating a local or regional government higher than the sovereign.”
Also on Thursday, S&P revising the rating outlook on the four domestic major banks to negative from stable, it affirmed the credit ratings at AA-:
“…it revised the rating outlooks on the following four major banks in Australia to negative from stable: Australia and New Zealand Banking Group Ltd., Commonwealth Bank of Australia, National Australia Bank Ltd., and Westpac Banking Corp. At the same time, we affirmed the 'AA-' long term and 'A-1+' short term issuer credit ratings on each of the banks. These actions follow our revision of the sovereign rating outlook on the Commonwealth of Australia earlier today to negative from stable.”
So what does a negative outlook actually mean?
According to S&P, a negative (or positive) outlook:
“…assesses the potential direction of a long term credit rating over the intermediate term (typically six months to two years). In determining a rating outlook, consideration is given to any changes in the economic and/or fundamental business conditions. An outlook is not necessarily a precursor of a rating change or future CreditWatch action.”
In Australia’s case:
“There is a one in three chance that we could lower the rating within the next two years if we believe that parliament is unlikely to legislate savings or revenue measures sufficient for the general government sector budget deficit to narrow materially and to be in a balanced position by the early 2020s. We will continue to monitor, over the next six to 12 months, the success or otherwise of the new government's ability to pass revenue and expenditure measures through both houses of parliament.”
Moody’s defines a negative (or positive) outlook slightly differently:
“A Moody’s rating outlook is an opinion regarding the likely rating direction over the medium term.”
So what does Moody’s define as the ‘medium term’?
“On average, after the initial assignment of a positive or negative rating outlook, the next rating action – either a change in outlook, a rating review, or a change in rating – has followed within about a year, but outlooks have also remained in place for much shorter and much longer periods of time.”
After the outlook has changed, Moody’s states:
“The next rating action subsequent to the assignment of a negative (positive) rating outlook has historically been a downgrade or review for possible downgrade (upgrade or review for possible upgrade) about one half of the time.”
Given that a review to a rating at Moody’s leads to an actual change in the rating over 50% of the time (see below), the chance of a ratings downgrade following on from a negative outlook is about 30%.
So what does a CreditWatch Negative (S&P) or Review for Downgrade (Moody’s) actually mean?
For S&P:
“CreditWatch highlights our opinion regarding the potential direction of a short term or long term rating. It focuses on identifiable events and short term trends that cause ratings to be placed under special surveillance by S&P.”
S&P does not formally state what percentage of ratings on CreditWatch leads to a formal rating change but it is widely assumed to be about 50%.
At Moody’s:
“A review indicates that a rating is under consideration for a change in the near term. A rating can be placed on review for upgrade (UPG), downgrade (DNG), or more rarely with direction uncertain (UNC) […] For the majority of reviews, however, where the conclusion of the review is not dependent on an event whose timing Moody’s cannot control, reviews are typically concluded within 30 to 90 days.”
And following Moody’s ratings review process:
“Ratings on review for possible downgrade (upgrade) have historically concluded with a downgrade (upgrade) over half of the time.”
Practicalities
The move from S&P is basically a warning shot across Australia’s bows; if the government doesn’t change course it will hit the iceberg and lose its coveted AAA rating. I don’t think that this should be a major concern for investors, as Australia and its banks are still highly likely to be able to secure attractively priced offshore funding. In this current environment, the chase for yield continues so that any increase in funding costs is likely to be small.
Conclusion
When talking about credit ratings it is critically important to understand the difference between a CreditWatch Negative/Review for Downgrade and a negative outlook. The former are much more serious designations – generally a 50% chance of a downgrade within 3 months – than the latter (outlook) – which signals a 1 in 3 chance of a downgrade within the next 2 years.
Ok I’m dismounting my high horse. Giddy up!