Years 2013 and 2014 have been unpleasant for governments that have seen their sovereign ratings downgraded for various reasons. Globally, out of the 113 countries rated by S&P, the number of AAA rated countries reduced to just 11 in 2014 from 17 at the start of 2011.

1. Are sovereign credit ratings anachronistic?
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Sovereign Debt Ratings: Anachronism in today’s age?
Years 2013 and 2014 have been unpleasant for governments that have seen their sovereign ratings downgraded for various
reasons. Ratings agencies have not spared even the world’s most credit worthy nation – the US; S&P downgraded its AAA rating,
bringing down the pool of AAA rated countries to 11 and investible sovereign debt to USD 4 trillion from USD 11 trillion in one go.
However, bond investors have ignored the revised ratings. The yields for US 10-year treasury improved ~75 basis points in 2014
alone, boosted by expectation of inflation easing in the US. Separately, rating or outlook downgrade of several other nations has had
no major impact on sovereign yields. This questions the veracity of sovereign ratings and credit agencies. Are investors able to
perceive markets differently from rating agencies? Are rating agencies right, and will the market discover risks over time? The
answers may lie somewhere in the middle, and are better understood in terms of what each one comprehends in terms of risks –
absolute credit risk (indicated by sovereign ratings) or relative rating (indicated by sovereign debt yields).
AAA sovereigns: Endangered species on verge of extinction?
The International Union for Conservation of Nature (IUCN) categorizes endangered (EN) species as one that is likely to become extinct.
However, recognizing species as endangered does not always save it from extinction like the tigers of Java (which were strong and
powerful, yet became extinct). It would not be an exaggeration to look at the economies of the world and see a similar pattern of
endangerment in case of AAA rated sovereigns.
Couple of months ago, S&P downgraded Finland’s sovereign credit rating from AAA to AA+. This shrunk the pool of AAA rated
European countries to just three: Sweden, Norway and Denmark. Globally, out of the 113 countries rated by S&P, the number of AAA
rated countries reduced to just 11 in 2014 from 17 at the start of 2011. Notable exits since the financial crisis have been the developed
economies such as the US, France, Finland and the Netherlands. Consequently, the pool of ‘prime’ investible sovereign debt shrunk
proportionately to just USD 4 trillion from approximately USD 11 trillion at the beginning of 2007, primarily due to the exit of the US from
the AAA club. In the case of Finland, S&P downgraded the rating as primarily ‘the economy faces protracted period of stagnation and
an aging population… Above-average wage growth and below-average productivity have exacerbated the country’s economic
sclerosis’.
Number of Sovereigns with AAA rating
Source: S&P, Aranca Research
17
14
12
11 11
0
4
8
12
16
20
2010 2011 2012 2013 2014

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Did anyone miss the AAAs?
For all the coveted status of AAA rating, the shrinking pool of such sovereigns has hardly caused a flutter in the financial world. The
reason is obvious once we look at the relative sizes of these countries. Just four of these 11 countries – Germany, UK, Australia and
Canada – have GDP size of more than USD 1 trillion. The combined GDP of these 11 countries accounted for just ~16% of the world
GDP in 2014. Of these 11, GDP of six countries is less than the market capitalization of Apple and other top 10 Fortune 500 companies
as of end-2014. The sub-group of European AAA sovereigns is even more peculiar. None of them – Sweden, Norway and Denmark – is
part of the European Union and each has its own currency.
AAA rating downgrades: the issue with developed economies
The situation does not look too different for many developed economies facing similar structural issues. While slowing economic growth
due to demographic changes is leading to shrinking fiscal revenue base, fiscal costs to support an aging population is on an uptrend in
several advanced economies. From time to time, disruptive innovations and companies prolong the inevitable. For instance, in Finland,
Nokia rose to dominate the mobile phones market; however, the advent of Apple, Samsung and the likes, as well as Nokia’s own
strategic misfires impacted not just Nokia but the whole ecosystem of telecom companies in the country, impacting Finland’s fiscal
revenues from taxes. Therefore, governments need to foresee structural risks and take mitigating steps in time; else, there may be
more such downgrades until global economic growth revives.
Sovereign rating mechanism: do not shoot the messenger
The sovereign credit rating framework is quite comprehensive. In case of S&P, five key factors form the foundation of sovereign credit
analysis:
1. Institutional and governance effectiveness and security risks, reflected in the institutional and governance effectiveness score;
2. Economic structure and growth prospects, reflected in the economic score;
3. External liquidity and international investment position, reflected in the external score;
4. Fiscal performance and flexibility, as well as debt burden, reflected in the fiscal score; and
5. Monetary flexibility, reflected in the monetary score.
The framework is applied in a step-by-step manner.
S&P’s sovereign credit rating framework
Source: S&P

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Standard & Poor's Sovereign Rating Calibrations are stated as:
‘The overall calibration of the sovereign ratings criteria is based on analysis of the history of sovereign defaults, the effect of the 2008-
2009 financial and economic crisis on sovereign creditworthiness, and S&P's view of the credit strengths of sovereign governments
compared with those of other issuers.’
Each rating change is deliberated upon and substantiated to the extent possible for better communication to the policy makers of the
country as well as analyst and investment communities. The agencies do not just look at the process mathematically but also undertake
qualitative assessments of sovereign credit risks. For example, while downgrading the AAA rating of the US, S&P cited political risks
(read political brinkmanship in delaying raising the debt ceiling until the last minute in 2011) as one of the factors for rating downgrade.
S&P stated at the time of downgrade that ‘…the downgrade reflects our view that the effectiveness, stability, and predictability of
American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more
than we envisioned when we assigned a negative outlook to the rating on April 18, 2011’.
However, sovereign yields defy conventional logic
The ratings downgrade and host of structural issues notwithstanding, sovereign debt yields continue to move in the opposite or
favorable direction — a classic case of ‘In the land of the blind, the one-eyed man is king’. Yield changes in Finland (41 bps
improvement in three months since the downgrade) may appear perplexing at first; however, improvement in yields is a similar story
that has repeated for all major sovereigns over the recent and distant past.
Improvement in sovereign yields despite rating downgrade
Country
Rating change
No of
downgrades
Current
10-yr
sovereign
yield (%)
Changes in 10 year sovereign debt yields (basis points) over
past periods
2011 2014 3 mon 6 mon 12 mon 2 yrs 3 yrs 5 yrs
USA AAA AA+ 1 2.2 (0.32) (0.33) (0.82) 0.43 0.31 (1.65)
France AAA AA 2 0.8 (0.46) (0.77) (1.61) (1.17) (2.33) (2.79)
Japan AA- AA- 0 0.3 (0.20) (0.24) (0.41) (0.48) (0.66) (0.97)
Spain AA- BBB 2 1.6 (0.57) (1.07) (2.55) (3.71) (3.50) (2.38)
Italy A BBB- 3 1.9 (0.46) (0.84) (2.21) (2.64) (5.11) (2.25)
Portugal BBB- BB 1 2.7 (0.47) (0.96) (3.35) (4.31) (10.87) (1.37)
Netherlands AAA AA+ 1 0.7 (0.42) (0.81) (1.56) (0.82) (1.50) (2.88)
Austria AAA AA+ 1 0.7 (0.44) (0.85) (1.57) (1.04) (2.20) (3.16)
Finland AAA AA+ 1 0.6 (0.41) (0.80) (1.50) (0.87) (1.66) (2.92)
Source: Thomson Reuters, S&P

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10-year benchmark sovereign yields(%) have kept falling for past two years
Source: Thomson Reuters
The divergence between rating downgrades and improvement in yields appears perplexing. The apparent conclusion drawn from this
trend is that debt investors are sidelining sovereign debt ratings by rating agencies. This view is further reinforced by statements from
asset managers such as Vimal Gor, Head of Income and Fixed Interest at BT Investment Management, who says, “I don't know
whether anyone really pays attention to sovereign credit ratings anymore”. As such the rationale for sovereign credit ratings appears to
be questioned. However, although ratings are not being considered for fine pricing of sovereign credit risk, there is still an audience for
credit ratings among the investor and analyst communities.
Rating vis-à-vis Debt yields: Absolute risk vis-à-vis Relative risk
A more plausible explanation for the divergence may be the difference in the way credit rating agencies and investors look at sovereign
risk. Credit rating agencies attempt to assess credit risk on its own merits, irrespective of how the market may be pricing the risk. While
agencies do consider the credit strengths of sovereign governments compared with those of other issuers, the current market pricing
(debt yields) do not figure in risk assessment. This is necessary to isolate the risk assessment from the influence of market gyrations
and for consistency and fairness in risk assessment. However, this also leads to assessment of credit risk on absolute basis. Investors,
on the other hand, appear to consider relative credit risk. Hence, the relative attractiveness of sovereign debt of select countries has
remained high despite changes in sovereign ratings. The best example may be that of the US. In spite of being stripped of the coveted
AAA rating, US Treasuries continued to remain in demand, leading to improvement in yields by more than 100 bps since the
downgrade. Similarly, Japanese bonds yields moved in the opposite direction following downgrade of the country’s outlook recently.
Conclusion
Sovereign ratings may not carry the same weight as they did several years ago. The failure of rating agencies in flagging off risks in the
housing market during the sub-prime crisis partially impacted their credibility. More importantly, with central banks pumping
extraordinary measures to save economies from slipping into recession, investors have realized the need to assess relative risk rather
than absolute risk. That may perhaps explain the divergence in ratings movements and sovereign yields. This divergence may continue
further until central banks revert to their traditional role of being lender of last resort and not the first resort.
Research Note by Nikhil Salvi with contribution from Akash Agrawal
-
4.0
8.0
12.0
16.0
0
2
4
6
8
Jul-08 Aug-10 Sep-12 Oct-14
USA Japan Italy
France Spain Portugal - RHS
Netherlands Austria Finland

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