Advisor Blog

In early August, Standard & Poor's downgraded US government debt from a top-rated AAA to AA+.¹ In the weeks preceding the event, most market observers expected a downgrade to result in higher interest rates and lower stock returns.  After the downgrade, yields on US government securities fell across the term spectrum as investors around the world fled to the safe haven of US bonds. US stocks experienced negative returns in the following weeks but logged positive performance from the day of the downgrade to month end.²

These events raise questions about whether changes in sovereign debt ratings impact the financial markets. The short answer is that results are mixed, and that many other factors affect a country's cost of capital and stock market returns.

Regarding bond markets, history offers examples of major developed countries that experienced a credit downgrade without a significant rise in interest rates.³ Examples include Australia, Canada, and Japan, which lost their top ratings in 1986, 1992, and 1998, respectively.

Other research suggests that countries with high credit ratings may withstand a downgrade better than countries with lower ratings. One study looked at sovereign credit rating downgrades since 1990 and found that bond yields changed little among countries downgraded from the highest triple-A rating. However, countries with lower credit ratings (single A or below) experienced significant interest rate increases following their downgrade.⁴

Stock market impact

Another question is whether the US downgrade has played a role in the US stock market downturn—and research does not provide convincing evidence.

Below is a chart that summarizes stock market performance of respective countries before and after a ratings change. It is based upon a study of ratings changes made by Moody's from 1983 to 2009. During the twenty-seven-year period, the ratings agency made seventy-one upgrades and twenty-five downgrades to governments in the developed and emerging markets tracked by MSCI.

The study identified the date of each change and logged each country's market performance in the twelve months before and twelve months after the event. Each country's market returns were compared to the respective market index and the excess return averaged for all events. (Excess return refers to performance above or below the respective market index, either MSCI EAFE or MSCI Emerging Markets, as appropriate.)

Figure 1. Equity market performance before and after Moody's ratings changes, 1983–2009

Analysis conducted by Dimensional Fund Advisors using sovereign bond rating data from Moody's Investors Services, "Sovereign Default and Recovery Rates, 1983–2009." Returns are in US dollars and represent performance in excess of MSCI EAFE Index for developed markets and MSCI Emerging Markets Index for emerging markets. A positive excess return indicates market outperformance; a negative excess return indicates underperformance. The table reports the return of an equal-weighted, event-time portfolio. Past performance is no guarantee of future results.

The aggregate results show that stock markets of upgraded countries outperformed their respective market index in the twelve months before the rating change (13.83%), while stocks in downgraded countries aggregately underperformed the market index before the event. However, cumulative returns in the twelve months following a ratings change were almost the same for the upgraded and downgraded countries (3.87% vs. 3.73%).⁵

These results suggest that market prices reflect all available information and expectations about a country's economic prospects—including the possibility of a ratings change. By the time a country's debt rating is upgraded or downgraded, the market has already integrated the news into prices. Stock markets reflected positive economic developments prior to a ratings upgrade and negative developments before a ratings downgrade. After the event, markets did not appear to perform much differently, in aggregate.

Conclusion

This research underscores the importance of looking to market prices for signals about the fiscal health and prospects of a country or a company. Based on the foregoing analysis, markets appear to work faster and more accurately than ratings firms to assess a country's financial condition and evaluate the potential impact on its cost of capital and equity market.

1. A sovereign credit rating is an assessment of a government's ability to pay its debts. The US had held S&P's top rating since 1941. S&P made the announcement after business hours on Friday, August 5, but word of the downgrade leaked during the day. Although timing of the announcement was a surprise, the downgrade was mostly expected, as S&P had issued a negative long-term outlook for the US in April and July. The other top credit agencies, Moody's Investors Service and Fitch Ratings, have maintained top ratings for the US.

2. Two weeks following the downgrade, the US market, as measured by the Russell 3000 Index, logged a negative 6.82% return (August 5–19). However, from the day of the announcement to month end, the market returned a positive 1.6%. Russell data copyright ©Russell Investment Group 1995–2011, all rights reserved.

3. Tom Lauricella, "Lessons of Lower Ratings," Wall Street Journal, July 30, 2011.

4. Ivan Rudolph-Shabinsky and Dennis Shen, "When 'Risk-Free' Isn't Risk Free: The Impact of a US Treasury Downgrade" white paper, Alliance Bernstein, June 2011.

5. The twelve-month aggregate excess performance prior to the ratings change was statistically significant, while the twelve-month returns after the ratings change were not.

What is the best signal for investors worried about the risks posed by investing in sovereign bonds? Does one look at the relative size of countries' debt, the nature of their borrowings or their credit ratings? Or is the market itself the best guide?

With the strained balance sheets of governments in the Europe and US the focus of so much media and market attention in recent times, it is understandable that investors would fret about the risks of putting their money into sovereign bonds. Alongside the sheer size of the liabilities being accumulated by many governments, the often reckless behavior of politicians of all stripes on either side of the Atlantic in seeking to deal with these policy issues hardly inspires confidence.

For example, how does a country like France, with total government debt of nearly 70 per cent of its economic output, maintain a top tier 'AAA' bill of health from all the major credit rating agencies—Moody's, Standard & Poor's and Fitch?

Correspondingly, how does a country like Japan, with an even bigger proportionate debt load (184 per cent of GDP) than beleaguered Greece (148 per cent), maintain a superior credit rating (AA/AA–) to the junk paper of the Greeks (CCC/CC)?

And how does the United States—supposedly the safest of all safe havens—hold a AAA/AA+ credit rating when it has the biggest nominal debt load of any country at nearly $US15 trillion or just over 60 per cent of its economic output?

So what should we pay attention to: The nominal debt, the proportionate load, the interest bill or the credit rating? And if we decide the credit rating is the best guide, whom do we believe: Moody's, S&P or Fitch? For instance, while S&P recently downgraded the US to AA+ with a negative outlook, Fitch later confirmed the US as AAA. It's confusing, isn't it?

Listening to the Market

But there is an alternative, and that is the market price. Specifically, there is a very large market in a form of derivatives called 'credit default swaps' or CDS. These are a form of insurance policy that some investors take out against a loan default. There are CDS for corporate borrowers and for sovereign borrowers. This very liquid market serves as a useful guide to how the market views the relative risk of default among various sovereign borrowers. And it is clear that risk as judged by the market and the risk as judged by credit rating agencies are not necessarily the same.

For example, seven months before it defaulted in 2008, Ecuador was rated 'BBB' by Standard & Poor's. Yet, its bonds were yielding around nine percentage points above those of US Treasury bonds, which implied a risk associated with a 'CCC' rating, according to a report by the International Monetary Fund. And, this isn't a one-off quirk. Chart 1 below maps the prices of credit default swaps (the vertical axis) for 26 different sovereign borrowers (the horizontal axis). Marked against the individual chart points are the average credit ratings—based on the three major agencies—for the individual countries.

Broadly speaking, the higher the price of default insurance for each sovereign borrower, the greater the market sees the risk of investors not getting their money back.

Not surprisingly, the most expensive CDS—as of August 2011—were those for Greece, which also happened to be the lowest rated country in this sample. The least expensive CDS were for Norway, a AAA-rated borrower with a low debt burden. So far, so good.

But now look at the US, which was downgraded by S&P, but whose cost of default insurance was lower than that of France, which maintained a AAA rating at time of writing. Or compare Mexico, with the lowest investment grade rating of 'BBB', whose default insurance actually cost less than AA-rated Spain.

The point of this is that the market believes the US, while fiscally challenged, retains sufficient flexibility to raise funds if needed. On the other hand, some of the European borrowers—locked into the monetary settings and debt constraints of the European Union—were seen by the market as having less flexibility.

Now look at the second graphic, Chart 2, below. This charts the total debt-to-GDP ratios (vertical axis) of seven countries in our sample with the price of their individual credit default swaps (horizontal axis).

Again, Greece was the most expensive country to insure and Norway the cheapest when we took this snapshot. But then look at Japan, whose total debt in proportionate terms is the highest of them all, but whose CDS were only marginally more expensive than those of Chile (the least indebted of all the nations in our sample). Incidentally, Australia—also one of the least indebted sovereigns in the developed world—was judged by the market as actually a higher credit risk than the US.

So, which offers the best signal: the credit rating agencies, the economic fundamentals or the market? The answer to that question is that no one knows for sure, because no one has found a way of correctly and reliably forecasting the future. But in pricing risk, it is usually better to give greater weight to market signals—if for no other reason than the price represents the combined wisdom of millions of market participants staking real money on the outcome.

While credit ratings and debt-to-GDP ratios are important, the market ultimately judges sovereign risk on both the perceived ability of sovereign borrowers to find new sources of revenue as needed and the perceived willingness of those borrowers to repay.

So while the US undoubtedly is stretched, it is perceived by the market as having the capacity to fund its liabilities relatively easily through tax increases and/or additional spending cuts. It also has the advantage of being able to borrow in its own currency in capital markets and is less reliant than the Europeans on bank funding. Markets incorporate all these pieces of information—economic variables, credit ratings, risk perceptions, willingness to pay—and put a price on them.

Sovereign risk is called as such because it is a risk, like any other. Countries can and have defaulted. As recently as 2010, Jamaica defaulted on its debt. Others to default in the past decade have included Ecuador (2008), Belize (2006), Dominican Republic (2005), Uruguay and Nicaragua (2003), Moldova (2002) and Argentina (2001).

Summary

The way to deal with those risks are the tried and true methods of working with the market, diversifying broadly, taking risks only when there is a demonstrated reward for doing so and basing one's strategy on a long-term, scientifically proven research and a consistent philosophy.

The size of a country's debt—both in nominal and proportional terms—is one input to this process, as is its credit rating. But also important is the market's perception of a country's ability and willingness to raise new revenues, reduce outlays and pay back its debt. Ultimately, all this information is reflected in market pricing.