By: Mike Campbell
The function of a ratings agency is to provide a realistic assessment of the risk that an investor runs when he buys a bond from a corporation or sovereign state. The lower the perceived risk, the smaller the interest rate that a borrower must pay to attract the investment they seek. Conversely, as perceived risk increases (i.e. the issuer is more likely to default on their obligations), the borrower has to pay more interest to compensate for the higher risk and attract investors. The body that issues the bond pays the ratings agency a percentage of the bond issue for this service.
Japan has the greatest level of debt of any industrialised nation; more than twice the country’s GDP. With the disaster that struck on 11th March, Japan is faced with a massive reconstruction bill which it assesses as $309 billion, but it has indicated that it will avoid using a bond issue to generate the funds needed. However, ratings agency Standard and Poor’s has decided to downgrade the rating on the outlook for Japan’s sovereign debt to negative. The move does not mean that Japan’s borrowing costs will immediately rise, but shall we say that storm clouds are gathering on the horizon?
S & P decided to downgrade Japan’s outlook because in their assessment, the cost of reconstruction were likely to be significantly higher than the government predicted – they put the bill at $612 billion and they think that Japan will need to raise money through issuance of government bonds. They cautioned that they would take further action (worsening the nation’s credit rating and pushing up borrowing costs) if the nation’s debt levels increased significantly. S & P also recently made such a downgrade of outlook for the US economy in view of its own debt burden.