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Since the start of the year, S&P has downgraded a number of major developed countries, including Portugal, Ireland, Greece, the United States, and, most recently, Italy. What’s behind the spate of downgrades and what do they mean for bondholders?

On September 19, Standard & Poor’s downgraded Italy’s sovereign debt rating by one notch to A from A+. The downgrade follows other recent downgrades of developed countries, including Portugal, Ireland, Greece, Spain, and the United States.

The reasons given for the Italian downgrade are similar to those behind the other downgrades: mounting government deficits and weakening growth prospects. More specifically, S&P announced that “the downgrade reflects our view of Italy’s weakening economic growth prospects and our view that Italy’s fragile governing coalition and policy differences within parliament will likely continue to limit the government’s ability to respond decisively to the challenging domestic and external macroeconomic environment.”

Rating agencies apply a host of quantitative and qualitative factors in assessing sovereign credit quality. Unlike corporate debt ratings, political risk, fiscal and monetary flexibility, and access to external funding are all factors unique to sovereign ratings. Corporate ratings tend to stick with a more quantitative approach.

Selected Sovereign Ratings (as of September 23, 2011)

Country Current Rating Date of Most Recent Change
United Kingdom AAA 1978
France AAA 1975
Germany AAA 1983
United States AA+ August 2011, down from AAA
Spain AA April 2010, down from AA+
Italy A September 2011, down from A+
Ireland BBB+ April 2011, down from A-
Portugal BBB- March 2011, down from BBB
Greece CC July 2011, down from CCC

For bondholders, the immediate effect of the downgrades is to increase rates and lower prices on new issues by the downgraded entities. A downgrade may also imply a drop in secondary market prices for existing issues, since the downgrade implies greater risk of default. However, this is not always the case, as recent experience with the U.S. downgrade has shown. Following S&P’s August 5 U.S. downgrade from AAA to AA+, prices on U.S. Treasuries actually increased, as investors worldwide turned from stocks to the safe haven of U.S. Treasuries.

Perhaps the most important factors that bondholders should consider in a downgrade are level and the trend. In the case of the United States, Spain, and Italy, all three countries still have ratings of A or higher — hardly default territory. Greece, on the other hand, is teetering on the edge of default, while Portugal and Ireland are both considered speculative grade. The trend is also important, as multiple downgrades, such as those seen by Greece, tell a story of their own.

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© 2011 McGraw-Hill Financial Communications. All rights reserved.

October 2011 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by D3 Financial Counselors, a local member of FPA.