Regaining focus on sovereign credit ratings

Recent events, including the downgrading of nine eurozone countries in January, and the US downgrade in August, have brought credit rating agencies (CRAS) and sovereign credit ratings firmly under the spotlight


This spate of activity has generated considerable coverage and debate, but also a certain amount of confusion, even amongst specialist investors.

1. Credit ratings are not assessments of investment merit. They are assessments of creditworthiness
An S&P credit rating is a forward-looking opinion about the creditworthiness of an obligor, in this case sovereign borrowers.

The rating is not an assessment of investment merit. Beyond creditworthiness, the rating does not offer information on aspects essential to making investment decisions. This is apparent in the very different market prices allotted to debt issues that possess the same credit rating.

Instead, the rating reflects S&P’s view on both the capacity and, importantly, the willingness of the borrower to meet its financial commitments in full and on time. The latter concern was at the heart of S&P’s one notch downgrade of the US in August, in response to the prolonged, contentious and fitful nature of the government’s debate on fiscal policy.

While credit quality may be a factor in investment decisions, there are numerous other factors investors may consider prior to deciding whether to buy, sell or hold. These include not only market price and liquidity, but the investor’s particular investment strategy, their tolerance for risk, the make-up of their portfolios and their assessment of a potential investment’s value in comparison with other investment opportunities. None of these factors are addressed by credit ratings.

Buying a car can prove a useful analogy in this regard. A reputation for reliability is often an important factor behind making a purchase, but it’s far from the only criterion under consideration.

2. Credit ratings are not absolute measures of default probability. They are opinions of relative creditworthiness.
Ratings convey opinions about the relative, not absolute, creditworthiness of an issuer, or the credit quality of an individual debt issue. That is because credit ratings are not an exact science – there are always going to be events and developments that are unexpected. Consequently, credit ratings are intended to express a Credit Rating Agency’s perspective on relative credit quality, from strongest to weakest, within a universe of credit risk. At S&P, these ratings range from ‘AAA’ (“the obligor’s capacity to meet its financial commitment on the obligation is extremely strong”) to ‘C’ (“obligations that are currently highly vulnerable to non-payment”), with ‘D’ ratings handed out when obligations are in payment default.

The likelihood of default is the most important factor in the ratings assessment. Norway, for example, has a credit rating of ‘AAA’. As such it is considered to have a higher credit quality than Serbia, which possesses a ‘BB’ rating. However, the ‘AAA’ rating is not a guarantee against Norway defaulting, but a statement that in S&P’s opinion Norway is less likely to default than Serbia.

3. Sovereign Credit ratings are not irrelevant. Studies demonstrate consistent results.
S&P publishes regular, detailed reviews of the performance of its ratings. These studies demonstrate that sovereign ratings have continued to perform well. Since 1975, an average of one percent of investment-grade sovereigns have defaulted on their foreign currency debt within 15 years, compared with around 30 percent of those at speculative grade. A study of sovereign ratings published in October 2010 by the IMF found that ratings provide a robust ranking of sovereign default risk, meaning that defaults tend to cluster in the lowest ratings grades, and noted that all sovereigns that have defaulted in the past 35 years had speculative grade ratings at least 12 months before default.

4. Sovereign Credit Ratings are not arbitrary.
This would be self-defeating. Sovereign ratings are based on published criteria that are applied consistently to more than 120 governments globally. Investors demand that the same criteria be applied universally in order to obtain a comparable view of credit risk across the globe.

S&P’s sovereign credit analysis is founded on five key factors, which are; institutional effectiveness and political risks; economic structure and growth prospects; external liquidity and international investment position; fiscal performance and flexibility (including debt burden); and monetary flexibility.

5. Credit Rating Agencies take account of political risk but do not pursue a political agenda.
S&P examines how political risk and policy initiatives, among many other factors, may affect its view of future creditworthiness. It does not suggest what policies governments should (or should not) pursue. An opinion on the effect of political risk on creditworthiness should not be confused with a political agenda. Which policies a government adopts to enhance growth prospects or to improve public finances is clearly for governments and electorates to determine. Nonetheless, history demonstrates that governance and political risk are among the main drivers of the economic policies that have led to sovereigns failing to meet their debt obligations. As a result, political risk factors have always been an important part of S&P’s analysis.

The downgrade of the United States in August 2011, for example, reflected the view that America’s governance and policymaking had become less stable, less effective, and less predictable. Likewise, S&P’s view that the response of eurozone policymakers to growing systemic stresses in the region has been ineffective was a key factor in its recent decision to downgrade a number of European sovereigns.

6. Credit Ratings Agencies are not unregulated.
Regulatory frameworks governing Credit Rating Agencies differ according to different geographies and jurisdictions. For example, in the United States, Credit Rating Agencies are registered under the Nationally Recognized Statistical Rating Organizations scheme (NRSRO), administered under the authority of the Securities & Exchange Commission. Likewise, in the European Union, the European Securities and Markets Authority (ESMA) is responsible for the supervision of Credit Rating Agencies, while in Hong Kong regulation is handled by the Securities and Futures Commission (SFC). These regulations include a range of standards that Credit Rating Agencies must comply with.

Credit Rating Agencies have a strong incentive to support regulation that helps enhance governance, enable transparency and, as a result, strengthens market confidence in ratings. S&P believes that regulation has strengthened market confidence in ratings by increasing oversight, transparency and accountability.

7. Sovereign credit ratings are not meaningless for sovereigns with control over their currency. Countries might still prefer to default.
In certain circumstances, default can emerge as a preferred policy action, even for sovereigns able to print money in the currency of issuance. Most sovereign defaults have occurred because a defaulting government’s past policies left it ill-prepared to face an unexpected turn of events. Recession, war, regime change, political instability, and sharp deterioration in terms of trade are examples of such shocks. When a government’s fiscal or monetary policies leave it little room for manoeuvre after a shock, or when economic policy does not support sustained economic growth, investors’ perceptions tend to change quickly. This, in turn, raises financing costs and, in some cases, leaves a government with default as the preferred policy response.

8. It is not the case that ratings simply follow market prices.
The history of the Eurozone shows that ratings and market prices often behave differently. For many years before the recent crisis, the market valued the bonds of sovereigns such as Italy, Portugal and Greece more or less on a par with AAA-rated German bonds. We always rated these sovereigns lower and started downgrading them as early as 2004, while the market continued to value them at a similar level to all Eurozone bonds. Similarly, the US downgrade by S&P in August 2011 was actually followed by a decline, rather than rise, in US government bond yields.

In general, ratings are much more stable than bond prices, which are influenced by multiple factors beyond ratings.

9. Market behaviour is not simply driven by ratings.
It is true that some financial institutions are mandated to only hold debt ascribed a certain rating (for example, ‘AAA’). Were this debt to be downgraded, these institutions may have to consider selling the debt.

However, alongside investors’ ability make their own decisions about credit risk and position themselves accordingly, investment mandates now regularly contain in-built flexibility, allowing institutions to respond discerningly and over time to ratings changes.

10. Market based measures of creditworthiness are not substitutes for credit analysis.
Following the financial crisis, some have argued for the use of market-based measures, such as credit spreads or credit default swap prices, as a means of assessing creditworthiness. While these measures can be useful complements to ratings, they are often highly volatile (much more so than ratings) and are available only for a relatively limited range of debt.

Although important, securities pricing data do not indicate why a company’s creditworthiness is strong or weak. Markets capture investors’ emotions with great speed and efficiency, but consequently, can overreact. Moreover, a great deal of evidence indicates that securities pricing is vulnerable to market illiquidity, unreliable information, asymmetrical information, investor herding, and differing investing and trading strategies.

What is more, the number of traded bonds and CDS contracts amounts to less than 3,000 names daily, representing only a fraction of the universe of rated securities covered by Credit Rating Agencies. Globally, there currently exist ratings on more than 300,000 corporate bonds, more than a million US municipal bonds, and well over 100,000 structured finance bonds.

Myriam Fernández de Heredia is Head of the Sovereign and Public Finance (IPF) group in EMEA, a role that she took over in September 2010. She manages a team of 50 analysts across EMEA. Myriam’s team covers 370 entities, including 75 sovereigns, 143 local and regional governments, and 147 supranational and government-supported entities in different sectors. Myriam joined Standard & Poor’s in 1994 and has combined experience in various analytical and managerial roles in the Sovereign IPF practice