Richard Cantor and Frank Packer
n recent years, the demand for sovereign credit ratings—the risk assessments assigned by the credit rating agencies to the obligations of central governments—has increased dramatically. More governments with greater default risk and more companies domiciled in riskier host countries are borrowing ininternational bond markets. Although foreign government officials generally cooperate with the agencies, rating assignments that are lower than anticipated often prompt issuers to question the consistency and rationale of sovereign ratings. How clear are the criteria underlying sovereign ratings? Moreover, how much of an impact do ratings have on borrowing costs for sovereigns? To explore thesequestions, we present the first systematic analysis of the determinants and impact of the sovereign credit ratings assigned by the two leading U.S. agencies, Moody’s Investors Service and Standard and Poor’s.1 Such an analysis has only recently become possible as a result of the rapid growth in sovereign rating assign-
ments. The wealth of data now available allows us to estimate which quantitativeindicators are weighed most heavily in the determination of ratings, to evaluate the predictive power of ratings in explaining a cross-section of sovereign bond yields, and to measure whether rating announcements directly affect market yields on the day of the announcement. Our investigation suggests that, to a large extent, Moody’s and Standard and Poor’s rating assignments can be explained by asmall number of well-defined criteria, which the two agencies appear to weigh similarly. We also find that the market—as gauged by sovereign debt yields—broadly shares the relative rankings of sovereign credit risks made by the two rating agencies. In addition, credit ratings appear to have some independent influence on yields over and above their correlation with other publicly availableinformation. In particular, we find that rating announcements have immediate effects on market pricing for non-investment-grade issues.
FRBNY ECONOMIC POLICY REVIEW / OCTOBER 1996
WHAT ARE SOVEREIGN RATINGS?
Like other credit ratings, sovereign ratings are assessments of the relative likelihood that a borrower will default on its obligations.2 Governments generally seek credit ratings to easetheir own access (and the access of other issuers domiciled within their borders) to international capital markets, where many investors, particularly U.S. investors, prefer rated securities over unrated securities of apparently similar credit risk. In the past, governments tended to seek ratings on their foreign currency obligations exclusively, because foreign currency bonds were more likelythan domestic currency offerings to be placed with international investors. In recent years, however, international investors have increased their demand for bonds issued in currencies other than traditional global currencies, leading more sovereigns to obtain domestic currency bond ratings as well. To date, however, foreign currency ratings—the focus of this article—remain the more prevalent andinfluential in the international bond markets. Sovereign ratings are important not only because some of the largest issuers in the international capital markets are national governments, but also because these assessments affect the ratings assigned to borrowers of the same nationality. For example, agencies seldom, if ever,
assign a credit rating to a local municipality, provincialgovernment, or private company that is higher than that of the issuer’s home country. Moody’s and Standard and Poor’s each currently rate more than fifty sovereigns. Although the agencies use
Table 2 SOVEREIGN CREDIT RATINGS As of September 29, 1995 Country Argentina Australia Austria Belgium Bermuda Brazil Canada Chile China Colombia Czech Republic Denmark Finland France Germany Greece Hong Kong...