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What are Sovereign Ratings?

Sovereign Ratings from AAA to Junk

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Sovereign ratings have become increasingly important as countries around the world tap the international bond markets. These credit ratings - issued to sovereign entities like national governments - take into account political risk, regulatory risk and other unique factors to determine the likelihood of a default. The three most popular issues of sovereign ratings are S&P, Moody's and Fitch.

Since they were introduced in the early 1900's, sovereign credit ratings have had a turbulent history. Moody's and other ratings agencies were taken by surprise after the Great Depression caused 21 out of 58 nations to default on their international bonds between 1930 and 1935. And since then, more than 70 governments have defaulted at least once on their domestic or foreign currency debt.

Where to Find Sovereign Ratings

The most significant sovereign ratings are published by the three major credit rating agencies - Standard & Poor's, Moody's and Fitch. While there are also a number of smaller boutiques that offer ratings, these three agencies have the most influence over market decision makers. Investors can find sovereign ratings from these three ratings agencies using the following links:

Other popular sovereign ratings firms include:

How Sovereign Ratings are Calculated

Ratings agencies use a variety of quantitative and qualitative methods to calculate sovereign ratings. But in a 1996 paper entitled "Determinants and Impact of Sovereign Credit Ratings", Richard Cantor and Frank Packer used a regression analysis to narrow the process down to six critical factors that explain more than 90% of the variation in credit ratings.

  1. Per capita income comes into play since a larger tax base increases a government's ability to repay debt, while it can also serve as a proxy for a country's political stability.
  2. Strong GDP Growth makes a country's existing debt easier to service over time, since that growth typically results in higher tax revenues and an improved fiscal balance.
  3. High inflation can not only signal problems with a country's finances, but also cause political instability over time.
  4. A country's external debt can be a problem if it becomes unmanageable.
  5. Countries with a history of defaulting are perceived to have a higher credit risk.
  6. More economically-developed countries are seen has less likely to default.

The Effects of Sovereign Ratings

Sovereign ratings have many effects on countries around the world. Several studies have shown that better sovereign ratings are associated with lower spreads. In turn, these lower spreads equate to lower financing costs for countries issuing bonds. Cantor and Packer estimated in the aforementioned report that a single notch downgrade can raise these spreads by as much as 25%.

The effects of these higher spreads and financing costs can include:

  • Inflation Risk. Central banks that print more currency to cover current and future debts risk causing inflation, which itself can lead to a number of economic problems.
  • Political Instability. Countries that are unwilling or unable to print more currency may undergo austerity measures to cut their costs, which can result in civil unrest.
  • Fewer Options. Central banks facing high borrowing costs may not find it as economical to provide stimulus packages or other growth incentives during difficult times.

However, other researchers remain skeptical. A study by Gonzalez-Rozada and Eduardo Levy Yeyati, entitled "Global Factors and Emerging Market Spreads", found that sovereign ratings reflect the changes in spreads instead of anticipating them. But in either case, sovereign ratings represent a useful tool for international investors to determine a country's investment quality.

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