Despite the criticism and calls for more transparency in the rating process (EU, 2011; Fang, Lai & Miller, 2009), a number of studies have shown that sovereign credit rating adjustments bring new information to the financial markets. Brooks, et al. (2004), for example, show that the sovereign credit rating adjustments have a cross asset impact in addition to influencing the rated bond issues. The authors show that sovereign credit rating downgrade announcements have a negative impact on aggregate equity stock returns as well as on the dollar value of the domestic currency (exchange rate). The cross asset impact of the sovereign credit rating adjustments was confirmed by Ferreira and Gama (2007) who also show across border contagion of the sovereign credit rating adjustment. The authors show that the sovereign credit rating for downgrade adjustment announcements have a significant negative spill-over effect, with the geographic proximity and emerging market status of the affected neighbouring country amplifying the impact. In addition, the impact extended to industry level, with the traded goods and small industry effect more pronounced (Ferreira & Gama, 2007).
Cavallo and Valenzuela (2007) concur, showing that in addition to firm-specific variables, debt issue characteristics and macroeconomic conditions, sovereign risk and global factors account for the variances in corporate bond spreads. The authors posit that the transfer of risk from a sovereign credit rating to the private borrowers will remain as the sovereign government has the power to levy taxes, impose capital controls or even seize the firm’s assets when government capacity so necessitates. Indeed, Borensztein, et al. (2007) point out that while agencies are gradually moving away from sovereign ceiling doctrine, it appears that sovereign ratings remain a significant determinant of the ratings assigned to corporates domiciled in the sovereign, even after controlling for macroeconomic factors as well as corporate performance indicators.
Cavallo and Valenzuela (2007) however, caution that transmission of risk from a sovereign to private borrowers was not universal, with the transmission from the sovereign to the private borrowers less significant for subsidiaries of multinational companies. This is supported by Cantor and Packer (1996b) and Durbin and Ng (2005), who found that some private corporate borrowers were rated more favourably than their sovereigns and that in some instances,
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corporate yield spreads were lower than similarly rated sovereigns. Durbin and Ng (2005) argue that investors tended to ignore the sovereign ceiling doctrine especially for firms with sustainable export earnings as well as those with close relationships with foreign parents or governments. In the case of South Africa, for example, Peter and Grandes (2005) found that for local currency ratings, the sovereign ceiling doctrine did not apply to multinationals and where the doctrine is applied, it is more pronounced for financial services firm spreads.
In addition to the asymmetric impact on private corporate borrowers, the impact of the sovereign credit ratings adjustment has been shown to be dependent not only on the type of the rating action (downgrade or upgrade), but also on the rating agency. A number of studies, for example, have shown that the rating adjustment impact was significant for downgrades and not for the rating upgrades (Brooks et al., 2004; Cantor & Packer, 1996a; Gaillard, 2009). Indeed, while Cantor and Packer (1996a) found that the sovereign credit rating upgrade and downgrade adjustments have an impact on the sovereign bond yields, the study found that the sovereign credit rating announcements were more pronounced for below investment grade ratings. Reisen and von Maltzan (1998) further show that the sovereign credit rating adjustments impact was significant only when a country was put on review for possible downgrade. This agrees with the findings by Ferreira and Gama (2007), who found that there was a negative stock market return spreads (the return differential vis-a-vis the US NY stock exchange) to a sovereign credit ratings downgrade but no significant reaction to upgrades. This is in line with the findings by Brooks, et al. (2004) and Hooper, et al. (2008) that the rating adjustment impact was dependent on the type of the economy, with the adjustment impact more pronounced for emerging markets economies whose credit ratings are usually of lower credit quality .
Brooks, et al. (2004) further show that only sovereign credit ratings issued by Fitch and S&P had a significant downgrade impact on aggregate stock returns as compared to those issued by Moody’s and Thomson. Gaillard (2009) concurs, showing that for sovereign bonds, the rating downgrade adjustment by S&P and upgrade adjustments by Moody’s have the most significant impact on yield spread movements. In addition, Gaillard (2009) shows that Moody’s issued sovereign credit ratings disagree more with the market than Fitch and S&P. This is contrary to
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the findings by Ratha, et al. (2007) who showed that there was a high correlation between sovereign ratings issued by different agencies, with bivariate correlation co-efficiencies ranging between 0.97 and 0.99 for Fitch, Moody and S&P in 2006. The authors argue that the differences in the ratings were found to be arising from the timing of the rating as opposed to the interpretation or biases by the rating agencies. While Cantor and Packer (1996a) confirm the consistency on assigned Moody and S&P ratings, they found that agencies differed more frequently on below investment sovereign bonds ratings than they do on corporate bonds. This, the authors suggest, was brought about by difficulties in assessing political and economic conditions for developing economies. The rating agencies (Moody, 2007; S&P, 2007) however suggest that the rating splits may be due to the analysts’ experience and judgement and not on any biases by the agencies, suggesting that the asymmetric reaction to the rating adjustments by the different rating agencies may be due to the market confidence in the respective agency capability.