The European Stability Mechanism (ESM) and European Financial Stability Facility (EFSF) were downgraded by Moody’s Investors Service, which cited a high correlation in credit risk present among the entities’ largest financial supporters.
The ESM was cut to “Aa1” from “Aaa,” while the EFSF provisional rating was lowered to “(P)Aa1” from “(P)Aaa.” Moody’s said in a statement yesterday that it would maintain a negative outlook on each.
The moves follow downgrades of the EFSF’s second-biggest contributor after France lost its top grade at Moody’s and Standard & Poor’s this year. Investors often ignore such ratings actions, evidenced by the drop in France’s 10-year bond yields since last week’s Moody’s downgrade and a rally in US Treasuries after the US lost its “AAA” rating at S&P last year.
The EFSF’s “rating is at the mercy of the creditworthiness of its biggest backers,” Nicholas Spiro, managing director of Spiro Sovereign Strategy in London, said before the move. “Another downgrade of the EFSF would show how the creditworthiness of the euro zone’s rescue fund itself is being affected by the worsening economic conditions in the core.”
About half the time, government bond yields move in the opposite direction suggested by new ratings, according to data compiled by Bloomberg in June on 314 upgrades, downgrades and outlook changes going back to 1974.
EFSF debt declined on the fund’s last credit downgrade, when S&P cut the rating by one level to “AA+” on Jan. 16. The yield premium over benchmark government debt of the EFSF’s 5 billion euros of 2.75 percent senior, unsecured bonds due July 2016 increased 13 basis points on the day of the downgrade to 155 basis points, according to Bloomberg prices. The spread has since narrowed to 55 basis points.
“There is a high correlation in credit risk among the entities’ supporters is consistent with the evolution to date of the euro area debt crisis and the close institutional, economic and financial linkages among the major euro area sovereigns,” the Moody’s statement said.
The Luxembourg-based EFSF was formed in 2010 to provide loans to cash-strapped EU countries. The ESM will replace the temporary EFSF, which has spent 192 billion euros of its 440 billion euros on loans to Ireland, Portugal and Greece. The two funds will run in parallel until the EFSF is phased out in the middle of next year.
The 500 billion euro ESM was set up to aid debt-swamped countries and declared operational on Oct. 8. The fund’s birth was eased by the European Central Bank’s offer in August to buy bonds of fiscally struggling countries, which has driven down interest rates in Spain and Italy and bought European governments time to address the root causes of the crisis.
Moody’s said after its Nov. 19 downgrade of France that it will assess the implications of the move for the ratings of the EFSF and ESM. It would focus on whether the support available from the remaining top-rated guarantors and shareholders is “consistent with the EFSF and ESM retaining the highest ratings,” the ratings firm said in a statement at the time.