It was a Friday night in August 2011. Finance professionals were kept awake after Standard & Poor's (S&P) announced it was downgrading its rating on U.S. debt from AAA to AA+.
The news sent shock waves across the world, and those vibrations were felt even more the following Monday, which left the market down over 6% by the end of the day. Yet, that market decline was benign compared to the individual beatings some stocks endured.
China was the next one on the chopping block. On Wednesday, May 24, 2017, rating agency Moody's downgraded the country's credit rating as growth slowed and debt increased. So, why do people care about this and what do these ratings mean?
- S&P's AAA rating is the highest assigned rating to any debt issuer and is the same as the Aaa rating issued by Moody's.
- AAA ratings are issued to investment-grade debt that has a high level of creditworthiness with the strongest capacity to repay investors.
- The AA+ rating is issued by S&P and is similar to the Aa1 rating issued by Moody's.
- It comes with very low credit risk and indicates the issuer has a strong capacity to repay.
Standard & Poor's rates the debt of countries and companies based on letter grades. The firm creates its ratings based on information such as annual reports, news articles, and company management. Analysts from S&P determine the company's or country's financial situation and other determining factors.
The letter grades the company assigns range from A to D with pluses and minuses to indicate how likely a borrower will repay its debt. Higher ratings come with triple letters, and grades that come with a plus are better than those with a minus.
What Does AAA Mean?
S&P's AAA rating is the highest that can be assigned to any issuer of debt. It is the same as the Aaa-rating issued by Moody's. This rating is assigned to investment-grade debt that has a high level of creditworthiness. Debt issuers with the highest ratings have the strongest capacity to repay investors. Their strong financial positions give them the lowest chance of default.
The United States had a AAA rating up until 2011 when it was downgraded to A+. As of June 2020, only a handful of countries had the strongest AAA rating, including Australia, Canada, Luxembourg, and Norway.
As it stands, only two U.S. corporations have a AAA rating as of February 2020: Microsoft (MSFT) and Johnson & Johnson (JNJ). This means the chance of default these two companies have compared to the U.S. government is lower. They're seen as having much lower credit risk with better debt profiles than the nation as a whole.
What Does AA+ Mean?
The AA+ rating is issued by S&P and is similar to the Aa1 rating issued by Moody's. This rating is of high quality and falls below the AAA ranking. It comes with very low credit risk, even though long-term risks may affect these investments. The AA+ rating is considered one of the rankings for investment-grade debt. Because they are financially strong, investments that are rated with an AA+ rating have a strong likelihood of repaying their debts, making the chance of default very low.
In addition to Moody's and S&P, the other big rating agency is Fitch. These three rating agencies are the "big three" that investors analyze.
As of January 2021, the S&P rating for the United States still sat at AA+ with a stable outlook. The fact that the U.S.—the world's largest economy—went from AAA to AA+ for the first time in history was a really big deal. In terms of stature, the downgrade was painful. Moody's, on the other hand, continued to rate the country with an Aaa rating, citing a stable outlook as well.
The Bottom Line
Whether your investment holds an AAA or AA+ rating, the difference doesn't really seem to matter. The market was upset and emotional, and the result was a panic-driven day like the end of 2008.
What always matters in this game is valuation and patience. Sticking to the simple philosophy of buying an asset below its long-term intrinsic value will ultimately lead to satisfactory results. It's a philosophy that is indeed simple to understand, yet difficult to execute for most investors.