Published: 09 August 2011 Topic: News,Money,Business Finance,Interest rates,Savings,Shares
Credit rating agency Standard & Poor's decision to downgrade the US government's rating from AAA to AA+ for the first time in history has sent global stock markets into shock.
However, Moody's and Fitch, the two other major ratings agencies, still rate the US government as AAA.
But what does the S&P downgrade mean, and what is the difference between an AAA rating and an AA+ rating anyway? Here, we explain what credit ratings are and why we have them.
What is a credit rating?
A credit rating evaluates the credit worthiness of a company or a government that issues debt in the form of bonds open to investors, in the opinion of credit ratings agencies such as S&P, Fitch and Moody's.
In other words, it signifies their evaluation of the financial strength of the institution in question, based on its ability to meet its financial commitments.
Individual and institutional investors considering buying their bonds can therefore use these ratings to get an idea of the risk they are taking before putting their money on the line.
Not everyone knows how to read these ratings, though.
Many consumers, for example, confuse them with the credit scores that banks and other lenders use to assess potential borrowers - which are in fact calculated very differently.
Different companies, different ratings
The fact that the major agencies vary in the way they present their ratings doesn't help.
Moody's, for example, uses letters as well as numbers, while Fitch and S&P use plus and minus signs.
all rate strength in a similar way, however, with an A-rated government or company deemed stronger and less risky than a C-rated institution.
A triple letter rating, such as AAA or BBB, is also always better than a double letter rating, such as AA or BB, regardless of whether the double letter rating is followed by a number or a plus or sign.
Consequently, the highest rating of AAA suggests that it is highly unlikely the bond issuer will default on their repayments, while a company with a single C rating should be viewed with extreme caution.
The flip side of investing in AAA-rated institutions only, however, is that the rate of return you receive will be lower because you are taking less risk.
And it is this that has got the Americans up in arms as the S&P downgrade to AA+ (the second-highest rating that it can award) will reduce the income the debt-ridden US government can make from the bonds it issues.
The agency cited the political gridlock over raising the national debt ceiling by up to $2.4 trillion, equivalent to around £1.5 trillion, earlier this month as the main reason for its decision.
S&P has stood firm against the wave of criticism unleashed by opponents of the move, many of who argue that it will only create more problems for the world's largest economy.Contrary to some expectations, however, S&P seems to take a more upbeat view of the Coalition government's spending cuts here as it has indicated that it does not expect Britain to lose its AAA rating - for the moment at least.