Musings on Markets: Sovereign Rankings, Default Threat and Markets: The Moody’s Downgrade Aftermath!

 I used to be on a household trip in August 2011 after I obtained an electronic mail from a journalist asking me what I assumed in regards to the S&P rankings downgrade for the US. Since I keep blissfully unaware of most information tales and issues associated to markets when I’m on the seaside, I needed to search for what he was speaking about, and it was S&P’s determination to downgrade the US, which had at all times loved AAA, the very best sovereign score  that may be granted to a rustic, to AA+, reflecting their issues about each the fiscal challenges confronted by the nation, with mounting commerce and funds deficits, in addition to the willingness of its political establishments to flirt with the opportunity of default. For greater than a decade, S&P remained the outlier, however in 2023, Fitch joined it by additionally downgrading the US from AAA to AA+, citing the identical causes. That left Moody’s, the third of the foremost sovereign rankings companies, as the one one which endured with a Aaa (Moody’s equal of AAA) for the US, however that modified on Could 16, 2025, when it too downgraded the US from Aaa (destructive) to Aa1 (steady). For the reason that rankings downgrade occurred after shut of buying and selling on a Friday, there was concern that markets would get up on the next  Monday (Could 19) to a wave of promoting, and whereas that didn’t materialize, the remainder of the week was a down week for each shares and US treasury bonds, particularly on the longest finish of the maturity spectrum. Quite than rehash the arguments about US debt and political dysfunction, which I’m positive that you simply had learn elsewhere, I assumed I might take this second to speak about sovereign default threat, how rankings companies price sovereigns, the biases and errors in sovereign rankings and their predictive energy, and use that dialogue as a launching pad to speak about how the US rankings downgrade will have an effect on fairness and bond valuations not simply within the US, however all over the world.

Sovereign Defaults: A Historical past

    Via time, governments have typically been depending on debt to finance themselves, some within the native foreign money and far in a overseas foreign money. A big proportion of sovereign defaults have occurred with overseas foreign money sovereign borrowing, because the borrowing nation finds itself wanting the overseas foreign money to fulfill its obligations. Nevertheless, these defaults, and particularly so lately, have been supplemented by nations which have chosen to default on native foreign money borrowings. I exploit the phrase “chosen” as a result of most nations  have the capability to keep away from default on native foreign money debt, with the ability to print cash in that foreign money to repay debt, however selected not to take action, as a result of they feared the implications of the inflation that may comply with greater than the implications of default.

Whereas the variety of sovereign defaults has ebbed and flowed over time, there are two factors value making in regards to the knowledge. The primary is that, over time, sovereign defaults, particularly on overseas foreign money debt, have shifted from financial institution debt to sovereign bonds, with thrice as many sovereign defaults on bonds than on financial institution loans in 2023. The second is that native foreign money defaults are persistent over time, and whereas much less frequent than overseas foreign money defaults, stay a big proportion of complete defaults.

    The results of sovereign default have been each financial and political. In addition to the apparent implication that lenders to that authorities lose some or an excessive amount of what’s owed to them, there are different penalties. Researchers who’ve examined the aftermath of default have come to the next conclusions in regards to the short-term and long-term results of defaulting on debt:

1. Default has a destructive impression on the financial system, with actual GDP dropping between 0.5% and a pair of%, however the bulk of the decline is within the first yr after the default and appears to be brief lived.
2. Default does have an effect on a rustic’s long-term sovereign score and borrowing prices. One examine of credit score rankings in 1995 discovered that the rankings for nations that had defaulted a minimum of as soon as since 1970 had been one to 2 notches decrease than in any other case related nations that had not defaulted. In the identical vein, defaulting nations have borrowing prices which might be about 0.5 to 1% increased than nations that haven’t defaulted. Right here once more, although, the results of default dissipate over time.
3. Sovereign default may cause commerce retaliation. One examine signifies a drop of 8% in bilateral commerce after default, with the results lasting for as much as 15 years, and one other one which makes use of business degree knowledge finds that export-oriented industries are significantly damage by sovereign default.
4. Sovereign default could make banking methods extra fragile. A examine of 149 nations between 1975 and 2000 signifies that the likelihood of a banking disaster is 14% in nations which have defaulted, an eleven percentage-point improve over non-defaulting nations.
5. Sovereign default additionally will increase the chance of political change. Whereas not one of the research deal with defaults per se, there are a number of which have examined the after-effects of sharp devaluations, which frequently accompany default. A examine of devaluations between 1971 and 2003 finds a forty five% improve within the likelihood of change within the high chief (prime minister or president) within the nation and a 64% improve within the likelihood of change within the finance government (minister of finance or head of central financial institution).

In abstract, default is dear, and nations don’t (and shouldn’t) take the opportunity of default evenly. Default is especially costly when it results in banking crises and foreign money devaluations; the previous has a longstanding impression on the capability of corporations to fund their investments whereas the latter create political and institutional instability that lasts for lengthy durations.

Sovereign Rankings: Measures and Course of

    Since few of us have the assets or the time to dedicate to understanding small and unfamiliar nations, it’s no shock that third events have stepped into the breach, with their assessments of sovereign default threat. Of those third-party assessors, bond rankings companies got here in with the most important benefits:

1. They’ve been assessing default threat in companies for 100 years or extra and presumably can switch a few of their abilities to assessing sovereign threat.
2. Bond traders who’re aware of the rankings measures, from investing in company bonds, discover it simple to increase their use to assessing sovereign bonds. Thus, a AAA rated nation is considered as near riskless whereas a C rated nation could be very dangerous. 

Moody’s, Normal and Poor’s and Fitch’s have been score company bond choices because the early a part of the 20th century. Moody’s has been score company bonds since 1919 and began score authorities bonds within the Twenties, when that market was an energetic one. By 1929, Moody’s offered rankings for nearly fifty central governments. With the Nice Despair and the Second World Conflict, investments in authorities bonds abated and with it, the curiosity in authorities bond rankings. Within the Seventies, the enterprise picked up once more slowly. As just lately because the early Nineteen Eighties, solely about 13  governments, principally in developed and mature markets, had rankings, with most of them commanding the very best degree (Aaa). The last decade from 1985 to 1994 added 34 nations to the sovereign score record, with a lot of them having speculative or decrease rankings and by 2024, Moody’s alone was score 143 nations, overlaying 75% of all rising market nations and nearly each developed market. 

Not solely have rankings companies turn out to be extra energetic in including nations to their rankings record, however they’ve additionally expanded their protection of nations with extra default threat/ decrease rankings.  In actual fact, the variety of Aaa rated nations was the identical in 1985, when there have been 13 rated nations, as in 2025, when there have been 143 rated nations. Within the final 20 years, a minimum of 5 sovereigns, together with Japan, the UK, France and now the US, have misplaced their Aaa rankings.  Along with extra nations being rated, the rankings themselves have turn out to be richer. Moody’s and S&P now present two rankings for every nation – a neighborhood foreign money score (for home foreign money debt/ bonds) and a overseas foreign money score (for presidency borrowings in a overseas foreign money). 

    In assessing these sovereign rankings, rankings companies draw on a mess of information, quantitative and qualitative. Moody’s describes its sovereign rankings course of within the image beneath:

The method is broad sufficient to cowl each political and financial components, whereas preserving wiggle room for the rankings companies to make subjective judgments on default that may result in totally different rankings for 2 nations with related financial and political profiles. The warmth map beneath offers the sovereign rankings, from Moody’s, for all rated nations the beginning of 2025:

Moody’s sovereign rankings

Be aware that the greyed out nations are unrated, with Russia being probably the most vital instance; the rankings companies withdrew their score for Russia in 2022 and never reinstated it but. There have been solely a handful of Aaa rated nations, concentrated in North America (United States and Canada), Northern Europe (Germany, Scandinavia), Australia & New Zealand and Singapore (the one Aaa-rated Asian nation. In 2025, there have been a eight sovereign rankings modifications, 4 upgrades and 4 downgrades, with the US downgrade from Aaa to Aa1 as the very best profile change

With the US downgrade, the record of Aaa-rated nations has turn out to be shorter, and as Canada and Germany battle with funds imbalances, the chances are extra corporations will drop off the record.

Sovereign Rankings:  Efficiency and Options

    If sovereign rankings are designed to measure publicity to default threat, how nicely do they do? The reply relies on the way you consider their efficiency. The rankings companies present tables that record defaults by score that again the proposition that sovereign rankings and default are extremely correlated. A Moody’s replace of default charges by sovereign rankings lessons, between 1983 and 2024, yielded the next:

Default charges rise as sovereign rankings decline, with a default price of 24% for  speculative grade sovereign debt (Baa2 and beneath) versus 1.8% for funding grade (Aaa to Baa1) sovereign debt.

    That mentioned, there are points of sovereign rankings that ought to give pause to anybody contemplating utilizing them as their proxy for sovereign default, they do include caveats and limitations:

1. Rankings are upward biased: Rankings companies have been accused by a few of being far too optimistic of their assessments of each company and sovereign rankings. Whereas the battle of curiosity of getting issuers pay for the score is obtainable because the rationale for the upward bias in company rankings, that argument doesn’t maintain up in the case of sovereign rankings, since not solely are the revenues small, relative to repute loss, however a proportion of sovereigns are rated for no charges.
2. There may be herd habits: When one rankings company lowers or raises a sovereign score, different rankings companies appear to comply with go well with. This herd habits reduces the worth of getting three separate rankings companies, since their assessments of sovereign threat are now not impartial.
3. Too little, too late: To cost sovereign bonds (or set rates of interest on sovereign loans), traders (banks) want assessments of default threat which might be up to date and well timed. It has lengthy been argued that rankings companies take too lengthy to alter rankings, and that these modifications occur too late to guard traders from a disaster.
4. Vicious Cycle: As soon as a market is in disaster, there may be the notion that rankings companies generally overreact and decrease rankings an excessive amount of, thus making a suggestions impact that makes the disaster worse. That is very true for small nations which might be principally depending on overseas capital for his or her funds.
5. Regional biases: There are numerous, particularly in Asia and Latin America, that consider that the rankings companies are too lax in assessing default threat for North America and Europe,  overrating nations in  these areas, whereas being too stringent of their assessments of default in Asia, Latin America and Africa, underrating nations in these areas. 

In sum, the proof means that whereas sovereign rankings are good measures of nation default threat, modifications in rankings typically lag modifications on the bottom, making them much less helpful to lenders and traders.

    If the important thing limitation of sovereign rankings is that they aren’t well timed assessors of nation default threat, that failure is alleviated by the event of the sovereign CDS market, a market the place traders should buy insurance coverage in opposition to nation default threat by paying an (annualized) value. Whereas that market nonetheless has points when it comes to counterparty threat and authorized questions on what includes default, it has expanded within the final 20 years, and in the beginning of 2025, there have been about 80 nations with sovereign CDS obtainable on them. The warmth map beneath offers an image of sovereign (10-year)  CDS spreads on January 1, 2025:

As you’ll be able to see, even in the beginning of 2025, the market was drawing a distinction between  the most secure Aaa-rated nations (Scandinavia, Switzerland, Australia and New Zealand), all with sovereign CDS spreads of 0.20% or beneath, and extra dangerous Aaa-rated nations (US, Germany, Canada). Throughout 2025, the market shocks from tariff and commerce wars have had an impact, with sovereign CDS spreads rising, particularly in April. The US, which began 2025 with a sovereign CDS unfold of 0.41%, noticed a widening of the unfold to 0.62% in late April, earlier than dropping again a bit in Could, with the Moody’s downgrade having nearly no impact on the US sovereign CDS unfold.

The US Downgrade: Lead-in and Aftermath

    With that background on sovereign default and rankings, let’s check out the story of the second, which is the Moody’s downgrade of the US from Aaa to Aa1. Within the weeks since, we have now not seen a significant upheaval in markets, and the query that we face as traders and analysts is whether or not something of consequence has modified because of the downgrade.

The Lead-in

    As I famous in the beginning of this publish, Moody’s was the final of the massive three sovereign rankings companies giving the US a Aaa score, with S&P (in 2011) and Fitch (in 2023) having already downgraded the US. In actual fact, the 2 causes that each rankings companies offered on the time of their downgrades had been rising authorities debt and politically dysfunction had been additionally the explanations that Moody’s famous of their downgrade. On the debt entrance, one of many measures that rankings companies use to evaluate a rustic’s monetary standing is its debt to GDP ratio, and it’s plain that this statistic has trended upwards for the US:

The ramping up of US debt since 2008 is mirrored in complete federal debt rising from 80% of GDP in 2008  to greater than 120% in 2024. Whereas a number of the surge in debt will be attributed to the exigencies brought on by crises (the 2008 banking disaster and the 2020 COVID bailouts), the troubling reality is that the debt has outlasted the crises and blaming the crises for the debt ranges right now is disingenuous. 

    The issue with the debt-to-GDP measure of sovereign fiscal standing is that it’s an imperfect indicator, as will be seen on this record of nations that scored highest and lowest on this measure in 2023:

Market Response

    The rankings downgrade was after shut of buying and selling on Friday, Could 16, and there was concern about how it will play out in markets, after they opened on Monday, Could 19. US equities had been really up on that day, although they misplaced floor within the subsequent days:

If fairness markets had been comparatively unscathed within the two weeks after the downgrade, what about bond markets, and specifically, the US treasury market? In spite of everything, an issuer downgrade for any bond is unhealthy information, and charges ought to be anticipated to rise to mirror increased default threat:

Whereas charges did go up within the the primary few days after the downgrade, the impact was muddled by the passage of a reconciliation invoice in the home that doubtlessly might add to the deficit in future years. In actual fact, by the Could 29, 2025, nearly the entire downgrade impact had light, with charges near the place they had been in the beginning of the yr.

    Chances are you’ll be stunned that markets didn’t react extra negatively to the rankings downgrade, however I’m not for 3 causes:

Penalties for valuation and funding evaluation

   Whereas the speedy financial and monetary penalties of a downgrade from Aaa to Aa1 shall be small, there are implications for analysts all over the world. Particularly, analysts should take steps when working with US {dollars} that they might already be taking already when working with most different currencies in estimating primary inputs into monetary evaluation.

    Let’s begin with the riskfree price, a primary constructing block for estimating prices of fairness and capital, that are inputs into intrinsic valuation. In precept, the riskfree price is what you’ll earn on a assured funding in a foreign money, and any threat premiums, both for investing in fairness (fairness threat premium) or in mounted revenue securities (default spreads), are added to the riskfree price. It’s normal follow in lots of textbooks and school rooms to make use of the federal government bond price as the chance free price, however that’s constructed on the presumption that governments can’t default (a minimum of on bonds issued within the native foreign money). Utilizing a Aaa (AAA) score as a (lazy) proxy for default-free, that’s the rationale we used to justify authorities bond charges as riskfree charges in the beginning of 2025, in Australian, Singapore and Canadian {dollars}, the Euro (Germany). Swiss francs and Danish krone. As we famous within the first part, the belief that governments do not default  is violated in follow, since some nations select to default on native foreign money bonds, quite than withstand inflation. If that’s the case, the federal government bond price is now not really a riskfree price, and attending to a riskfree price would require netting out a default unfold from the federal government bond price:

Threat free price = Authorities Bond price − Default unfold for the federal government 

The default unfold will be estimated both from the sovereign bond score (with a glance up desk) or a sovereign CDS unfold, and we used that course of to get riskfree in charges in a  host of currencies, the place native foreign money authorities bonds had default threat, in the beginning of 2025:

Thus, to get a riskfree price in Indian rupees, Brazilian reals or Turkish lira, we begin with authorities bonds in these currencies and web out the default spreads for the nations in query. We do that to make sure that we do not double rely nation threat by first utilizing the federal government bond (which incorporates default threat) as a riskfree price after which utilizing a bigger fairness threat premium to permit for a similar nation threat.  

    Now that the US is now not Aaa rated, we have now to comply with an analogous course of to get a riskfree price in US {dollars}:

• US 10-year treasury bond price on Could 30, 2025  = 4.41%
• Default unfold based mostly on Aa1 score on Could 30, 2025  = 0.40%
• Riskfree price in US {dollars} on Could 30, 2025 = US 10-year treasury price – Aa1 default unfold = 4.41% – 0.40% = 4.01%

This adjustment yields a riskfree price of 4.01% in US {dollars}, and it’s also constructed on the presumption that the default unfold manifested after the Moody’s downgrade on Could 16, when the extra sensible studying is that US treasury markets have been carrying a  default unfold embedded in them for years, and that we do not make it specific.

    The rankings downgrade for the US may also have an effect on the fairness threat premium computations that I exploit to estimate the price of fairness for corporations. As a few of you who observe my fairness threat premiums by nation know, I estimate an fairness threat premium for the S&P 500, and a minimum of till the beginning of this yr, I used that as a premium for all mature markets (with a AAA (Aaa) score because the indicator of maturity). Thus, nations like Canada, Germany, Australia and Singapore had been all assigned the identical premium as that attributed to the S&P 500. For nations with rankings beneath Aaa, I added an “further nation threat premium”  computed based mostly upon the default spreads that went with the nation rankings:

With the rankings downgrade, I should modify this course of in 3 ways. The primary is that when computing the fairness threat premium for the S& P 500, I should web out the adjusted riskfree price in US {dollars} quite than the US treasury price, yielding a better fairness threat premium for the US. Second, for Aaa rated nations, to the extent that they’re safer than the US will should be assigned an fairness threat premium decrease than the US, with the adjustment downward reflecting the Aa1 score for the US. The third is that for all different nations, the country threat premium shall be computed based mostly upon the the their default spreads and the fairness threat premium estimated for Aaa rated nations (quite than the US fairness threat premium):

How will the price of fairness for a agency with all of its revenues in the US be affected as a consequence? Let’s take three corporations, one below-average threat, one average-risk and one above common threat, and compute their prices of fairness on Could 30, 2025, with and with out the downgrade favored in:

As you’ll be able to see, the anticipated return on the S&P 500 as of Could 30, 2025, reflecting the index degree then and the anticipated money flows, is 8.64%. Incorporating the results of the downgrade modifications the composition of that anticipated return, leading to a decrease riskfree price (4.01% as a substitute of 4.41%) and a better fairness threat premium (4.63% as a substitute of 4.23%). Thus, whereas the anticipated return for the common inventory stays at 8.64%, the anticipated return will increase barely for riskier shares and reduces barely for safer shares, however the results are so small that traders will hardly discover. If there’s a lesson for analysts right here, it’s that the downgrade’s results on the low cost charges (prices of fairness and capital) are minimal, and that staying with the standard strategy (of utilizing the ten-year US treasury bond price because the riskfree price and utilizing that price to compute the fairness threat premium) will proceed to work.

Conclusion

    The Moody’s rankings downgrade of the US made the information, and far was made from it through the weekend that adopted. The monetary and financial penalties, a minimum of up to now, have been inconsequential, with fairness and bond markets shrugging off the downgrade, maybe as a result of the shock issue was minimal. The downgrade additionally has had solely a minimal impression on prices of fairness and capital for US corporations, and whereas that will change, the modifications will come from macroeconomic information or from crises. For probably the most half, analysts ought to be capable to proceed to work with the US treasury price as a riskfree price and forward-looking fairness threat premiums, as they did earlier than the downgrade. With all of that mentioned, although, the Moody’s motion does carry symbolic weight, one other indicator that US exceptionalism, which allowed the US to take financial and financial actions that may have introduced blowback for different nations, particularly in rising markets, is coming to an finish. That’s wholesome, in the long run, for each the US and the remainder of the world, however it would include brief time period ache.

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