Credit Rating

These days, we rate everything from movies to Uber drivers. The key rating for the economy is credit rating, which is an assessment of the creditworthiness of a borrower. It shows how likely the borrower is to repay its debt obligations. Credit ratings reveal the level of risk associated with investing in the debt of a particular entity. They can be assigned to any type of borrower: an individual, corporation, city, state, or sovereign government.

Usually, credit rating agencies assign letter grades to indicate ratings. For example,  Standard & Poor’s has a credit rating scale ranging from AAA (the borrower has extremely strong capacity to meet its financial commitments) to D (the borrower has defaulted on obligations and S&P believes that it will generally default on most or all obligations). All bonds with a credit rating below BB are seen as speculative or junk bonds.

The credit rating is of high importance, as the higher the credit rating, the lower the risk premium and the lower the interest rate charged by lenders. Whoever has a low credit rating, it will have to pay higher spread over the risk-free rate, or it could even be refused a loan.

Credit Rating and Gold
What is the link between credit rating and gold? First of all, please note that gold has the highest possible rating. Or, actually, it has no credit rating at all, as it has no counterparty risk. So, people who do not want to take credit risk, should consider allocating more funds into gold. Second, gold is a safe-haven asset, so it should provide a hedge against the highly risky debt instruments. Indeed, there is sometimes a positive correlation between gold prices and the level of risk premium. However, as the chart below shows, the relationship between the spread of junk bonds over Treasuries and the price of gold is rather loose.

_{Chart 1: ICE BofAML US High Yield CCC or Below Option-Adjusted Spread (red line, left axis, in %) and the price of gold (yellow line, right axis, London P.M. Fix, in $)  from January 1997 to October 2019.}

Credit Rating Downgrade
Credit ratings are never static. Instead, they change all the time based on the newest developments. When the borrower improves its credit rating, they can expect a credit rating upgrade. But if the borrower’s ability to pay back its obligation deteriorates substantially, there might be a credit rating downgrade. It means a negative change in the rating of a security, for example, from AAA to AA+.

By the way, this is the downgrade of the credit rating of the U.S. federal government made by the Standard & Poor’s on August 5, 2011, which was the first time when the U.S. federal government was given a rating below AAA.

Credit Rating Downgrade and Gold
Credit rating downgrades can be potentially supportive for the gold prices. If they relate to the U.S. and spurs the fears of recession or concerns about the sustainability of the federal debt, investors can rush to convert their fund to gold, the ultimate safe-haven. And indeed, the S&P’s downgrade of the U.S. public debt was beneficial for the gold prices. As the chart below shows, the negative change moved the price of the yellow metal from $1,433.5 on August 5 to $1,461.5 the next day.
Chart 2:

The immediate increase was not spectacular, but gold has continued its rally until September 2011, reaching over $1,900. Of course, the concerns about the U.S. public debt was not the only driver behind the gold bull market, or maybe even not the most important one, but they definitely help the yellow metal to shine.