By: Dr. Mike Campbell

Today’s chapter in the sovereign debt story is that the ratings agency Moody’s has decided to reduce its rating on Irish debt to “junk” status. The downgrade took the rating one notch lower from Baa3 to Ba1. The move signals Moody’s belief that any investors buying Irish bonds at the moment are likely to get their fingers burned as default is more of a possibility.

Again, it is worth remembering that Michael Milken made a fortune through investing in junk bonds in the seventies and eighties. It was junk bonds that financed an orgy of take-overs, mergers and acquisitions in those heady days. Junk does not mean that a bond has no value; just that it is a comparatively higher risk vehicle than a bond rated as a AAA investment. Milken’s Midas touch came from his recognition of the fact that the vast majority of “junk” bonds did not go into default – indeed, a small number of investment grade bonds have defaulted over the years. Rating is about probability and perception, not certainty.

Moody’s move will further anger officials at the European Commission and politicians across the Eurozone. The reason that Moody’s have advanced for the downgrade is that they believe that the Republic of Ireland may need a second bailout before returning to the commercial bond market when the current IMF/EU facility expires in 2013. Ireland (like Portugal and Greece) has already passed legislation aimed at reducing its debts through the imposition of stiff austerity measures.

As the credit rating declines, bond issuers are forced to offer higher interest to attract investors, so a vicious circle is started for heavily indebted nations which need to go to the market to service their existing debts through the generation of new bonds.