What have Standard & Poor’s been up to?

Last Friday, Standard & Poor’s downgraded the credit rating of nine euro zone states, including France and Austria, which lost their triple-A rating. This was followed on Monday by a downgrade of the euro zone rescue fund, the EFSF (European Financial Stability Facility), which funds the bailouts of countries such as Ireland and Portugal. The decision to downgrade the EFSF was not a surprise. It is guaranteed to the tune of €780 billion by six of Europe’s top-rated countries in order to go out and borrow in the markets. Once France, which provides 20 per cent of the guarantee, lost its triple-A rating the writing was on the wall for the EFSF.

What are the implications for the EFSF and why does it matter?

Market response over the last few days show that investors are not too bothered by the downgrades. Yesterday the EFSF successfully sold €1.5 billion of six-month bills at auction, with investors bidding for more than three times that amount, though some commentators pointed out that it may be a different story when longer-dated securities are up for auction.

Similarly, Spanish and Italian bond yields were down.

Why do markets appear to be ignoring the rating agencies?

One of the main reasons is that the markets have already priced in the downgrades.

In fact, Barclays Capital pointed out that the S&P rating action was not as dramatic as had been hinted at in early December.

Davy Stockbrokers described the downgrades as “more symbolic than financial”, pointing out that rating adjustments are more a lagging than a leading indicator of market valuations.

The other main reason for the market’s appetite for the bonds is that banks, the main purchaser of government bonds, have excess liquidity following the ECB’s massive three-year liquidity operation last month which lent nearly €500 billion to euro zone banks.

This also has a knock-on effect of attracting other investors, such as hedge funds, into the market.

What does it mean for us?

One of the fears arising from the EFSF downgrade was that it may have increased the costs at which the EFSF raises money, leading to a knock-on increase in the interest rate it charges Ireland and other bailout recipients. However, so far this does not seem to be the case, with the EFSF’s auction (albeit of six month bonds) over-subscribed yesterday.

Some commentators have pointed out that losing a triple-A rating isn’t as damaging as it used to be. Japan has already said that its purchase of EFSF bonds won’t be immediately affected by the rating cut, and the reality is that countries like the US and Japan themselves have double rather than triple-A ratings.

In addition the EFSF is due to be replaced by a permanent fund, the European Stability Mechanism in July.

Because this will be based on actual capital contributions from European countries rather than guarantees, it will be less vulnerable to rating changes in any event.