Sovereign Credit Ratings Explained: How Much Do Rating Downgrades Affect Stock Markets?

Investing

By Jonathan Hwa, Guest Contributor.

How much do credit rating downgrades really impact the markets in the short-to-medium term?

Currently, Moody’s and Fitch still give the U.S. a top AAA rating, but S&P downgraded the U.S. to AA+ after the 2011 debt ceiling debacle.  Meanwhile, Europe is currently experiencing a credit rating decline with credit downgrades seen across the ‘Euro Zone’ – and world – in the past year.

With all the talk surrounding deteriorating fiscal situations around the world and the resulting impacts on sovereign credit ratings, it is worth asking what effect this will have on stock markets.  The calculations presented below gives quantitative evidence that beyond initial knee-jerk reactions, markets are moved by the factors contributing to changes in ratings, and not by the downgrades themselves.

What are credit ratings?

A credit rating is assigned by certain objective third-party agencies, the main three of which are Moody’s, Fitch, and Standard & Poor’s.  The objective of a credit rating is to evaluate a debtor’s ability to repay debt and the likelihood of default; both countries and companies can be assigned these ratings. S&P represents this using a scale going from AAA as the most credit-worthy to D as being in default. Broadly speaking, these agencies determine ratings by examining the debtor’s credit history and future economic prospects. For example, a fast-growing country with optimistic expectations like China receives a higher rating of AA-, while a country in recession with a shakier credit history like Portugal has a relatively poor rating of BB.

You can see that S&P’s sovereign credit ratings are relatively bimodal, with a large number of AAA rated countries and many others in the non-investment grade B to BB- range.

 

 

 

 

 

 

 

 

Why are credit ratings important?

Credit ratings are universally used as an indicator of creditworthiness. Countries and companies with high credit ratings pay lower interest rates, while those with poor ratings pay high interest rates. For example, the United States currently pays about 1.6% on its 10-year bond, while Portugal pays 7.6%. These yields and ratings are often used as a proxy for the economic strength and political stability of the respective countries.

Changes in a country’s credit rating tend to be highly publicized, such as S&P’s downgrade of the United States last summer from AAA to AA+ (represented by the red line on the graph below). However, the actual impact of this downgrade is questionable, as government bond yields have actually decreased slightly in a somewhat paradoxical flight to “safety” as investors seemed even more eager to lend money to supposedly riskless Uncle Sam.

*data from Yahoo Finance

This disconnect between the rating downgrade and the reaction in the financial markets suggests that the actions of ratings agencies do not have large impacts on stocks and bonds past the initial knee-jerk reaction. While there are arguments both for and against the relevance of a credit rating downgrade to the markets, this article examines this issue from a statistical standpoint to determine whether or not investors actually care about what the agencies think.

Do credit ratings really matter?

Research using credit rating histories and stock index levels of developed countries over the last 15 years shows that sovereign credit rating downgrades do not have statistically significant impacts on stock prices.

Specifically, the average incremental return on the respective country’s stock index for the month after a rating downgrade as opposed to the month before was -2.9% with a 95% confidence interval of -13.9% to 8.0%. This means that in the selected countries, the respective stock index on average performed 2.9% worse for the month after a rating downgrade. However, since the confidence interval easily includes zero, this historical performance is so unpredictable that the difference is not statistically significant.

 

 

 

 

 

 

 

 

 

Results for sovereign credit rating upgrades as opposed to downgrades are similar, with incremental returns of 3.1% and a 95% confidence interval of -5.2% to 11.4%.

We can draw two related conclusions from these results; either the stock market doesn’t actually care about rating upgrades and downgrades beyond the initial knee-jerk reaction, or changes in ratings are obvious to investors for months before they are formally announced. In any case, it’s clear that investors shouldn’t care about a potential rating downgrade in the U.S. as much as the underlying reasons behind it.

What does this mean for financial markets?

Credit rating agencies are working with the same data that is available to the general public. Despite the supposed importance attributed to their ratings, the data suggests the market has recognized that downgrades in and of themselves mean nothing. The market moves on real data, not the hind-sighted actions of third-party rating agencies.

Standard & Poor’s may indeed downgrade the United States even further in 2013, depending on where we land on the fiscal cliff and the next debt ceiling debate, but the market knows that ratings themselves are irrelevant. Don’t expect them to be drivers of any stock market action beyond intraday price movements. Rather, shift your attention to the underlying issues at hand. An investor who fully understands and structures her trades around the fiscal cliff is in a much better position than the investor who does so around the trailing indicator of a credit rating downgrade.