Investing October 6, 2006, 5:53PM EST

Should You Invest in These Countries?

S&P gives 19 countries its highest sovereign rating of AAA. The better the rating, the lower the investment risk

by Karyn McCormack

On Sept. 19, Thai tanks rolled through the streets of Bangkok in a bloodless coup. The same day Standard & Poor's put the country's credit rating under review.

While credit ratings may not matter much to champions of democracy, foes of government corruption, or the Thai troops battling Muslim insurgents in the country's south, they can make a substantial difference to the

country's finances. If S&P lowers its ratings, it could hurt the Thai Finance Ministry's goal of strengthening the financial system to avoid a reprise of the country's fiscal crisis of 1997.

The reason is that just as average folks fret over their credit scores—which influence how much money banks will lend them and the interest rate charged—so do countries. When a country's sovereign credit rating is downgraded, it makes it that much more expensive for its government to borrow money.

Unlike private individuals, however, this information isn't provided by credit-score keepers Experian and Dun & Bradstreet (DNB), but by big rating agencies like Standard & Poor's, Moody's (MCO), and Fitch. The top tier of borrowers gets the agencies' coveted AAA rating. This means that the government has an extremely strong ability to pay its debt on time. "The higher the rating, the lower the perceived default risk and lower the premium it has to pay on its debt," says John Chambers, managing director of S&P Sovereign Ratings Group.

SCREENING TOOL.

Credit trends have been positive over the last year, thanks to strong global growth, rising commodity prices, ample cross-border capital flows, and low real interest rates, Chambers says. In the emerging-markets area, for example, Standard & Poor's Rating Services upgraded eight countries, by a single notch, and downgraded one in the last 12 months through August. The most recent upgrades were Indonesia (to BB- on July 26) and China (to A on July 27). Earlier this year, S&P upgraded South American countries Venezuela (to BB- on Feb. 3), Brazil (to BB on Feb. 28), and Argentina (to B on Mar. 23). Hungary was the only downgrade (to BBB+ on June 15).

Fixed-income traders and fund managers use sovereign ratings mainly as a screening tool to find securities. Don Quigley, co-manager of the Julius Baer Total Return Bond Fund (BJBGX), says his fund can buy only investment-grade bonds, so he looks for issues with a sovereign rating of BBB or higher. For example, he says he won't buy the debt of Turkey because its rating is below investment grade, but the fund currently has positions in Australia, Iceland, New Zealand, and Mexico. "We'll be aware of what its rating is, but it's really where the country's yield curve is vs. the U.S.," Quigley says. "We use it as a screening tool, but it's not what I rely on most."

To come up with a sovereign rating, S&P—which, like BusinessWeek.com, is a division of The McGraw-Hill Cos.(MHP)—looks at political risk, income and economic structure, growth prospects, fiscal balances, debt stocks, contingent fiscal risks, monetary policy, and external liquidity and external debt (debt owed to foreign creditors), Chambers says. S&P's highest rating is AAA, and anything BB+ and below is speculative, or not investment grade.

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