The role of a ratings agency is to provide investors with an impartial evaluation of the risks associated with a given debt vehicle, be it a commercial or a sovereign bond. The higher the perceived risk associated with a bond then the greater the level of interest investors will expect to be paid in order to accept the risk. The situation between a commercial bond and a sovereign bond is different in that it is not unheard of for a commercial concern to fail, meaning that investors will lose their money. In modern democracies, it is all but unheard of for a country to go bust, but of course Greece did partially default on its obligations earlier this year.
When the cost of sovereign borrowing becomes unsustainable (and interest rates consistently above the 7% mark is taken as the yardstick) then downgrades to a nation’s credit rating may precipitate a crisis that, in more sober times, could have been avoided – after all, the vast majority of “junk” bonds make it to maturity. Moody’s rating agency has just downgraded its assessment of the EU’s AAA rating to negative. Whilst the EU per se does not go to the market for funding, the European Financial Stability Facility has a mandate to raise funds from the market, so the cost of borrowing designed to underpin European financial institutions could indeed rise.
Moody’s defended their move by suggesting that were any of the big four European economies experience their own difficulties, they may prefer to put their own houses in order first before standing by their community obligations. "The negative outlook on the EU's long-term ratings reflects the negative outlook on the AAA ratings of the member states with large contributions to the EU budget: Germany, France, the UK and the Netherlands, which together account for around 45% of the EU's budget revenue," they said. Moody’s pointed out that the decision could be reversed if the prospects of the economies in question were to pick-up, of course.