have a direct impact on government bond prices and the domestic economy. Table 4 gives a summary of studies on sovereign ratings’ impact on sovereign bond spreads, bond yields and credit default swap (CDS) spreads. Despite different definitions of the dependent variable, the sample size, and the specification, all of these studies find that sovereign ratings lead to changes in the dependent variable in the expected direction. Though most studies focus on emerging market economies, earlier studies by Cantor and Packer (1996) and Larraín et al. (1997) confirm this result for a data set including developed countries from 1987-1994 and 1989-1996 respectively. For 18 high- and middle-income countries, Cantor and Packer show that relative sovereign bond spreads rise 0.9 percentage points on the day and the following in response to a negative rating announcement and fall 1.3 percentage points for a positive announcement (1996: 46). Afonso et al. (2011b) and Kiff et al. (2012) show that these findings also hold for developed countries’ CDS spreads.
Table 4 also provides a summary of the conditions under which sovereign ratings have a stronger impact on government bond and CDS spreads. First, downgrades have generally a stronger impact than upgrades. Second, rating changes in and out of investment grade have a particularly strong impact. Third, sovereign ratings matter more in crises episodes.
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Table 4: Studies on the Impact of Sovereign Ratings on Government Bonds
Study Data Set Finding and Dependent Variable (DV)
Cantor & Packer 1996 1987-1994, 18 high- and middle-income countries, S&P and Moody’s
DV: dollar bond yield spread compared to US Treasury rate
for two-day event window: increase by 0.9 percentage points for negative announcements and decrease by 1.3 percentage points for positive announcements
stronger impact for:
speculative-grade countries Moody’s announcements Larrain et al. 1997 1987-1996, 26 countries, S&P and Moody’s
DV: spreads to 10-year US treasury bonds
stronger impact for:
emerging-market countries review for possible downgrade Reisen & von
Maltzan 1999
1989-1997, 29 countries, S&P, Moody’s, Fitch
DV: relative dollar bond yield spreads
for two-day event window: change of 0.6 percentage points
stronger impact for: downgrades Sy 2001
1994-2001, 17 emerging markets,
S&P and Moody’s
DV: EMBI+ sovereign spreads, monthly data
decrease in sovereign spread by 14% Kaminsky & Schmukler 2002 1990-2000, 16 emerging markets, S&P, Moody’s, Fitch
DV: EBMI or EBMI+ sovereign spreads
average yield spreads increase by 2 percentage points
Gaillard 2009
1993-2007, 32 emerging markets, S&P, Moody’s, Fitch
DV: EMBI Global stripped spreads
stronger impact for:
downgrade from investment grade to speculative grade
Moody’s upgrades and S&P downgrades Ismailescu & Kazemi 2010 2001-2008, 22 emerging markets, S&P DV: sovereign CDS spreads
for upgrade and positive outlooks: decrease in average CDS spread by 11 basis points from day -1 to day 1 (2.23% drop in CDS premia)
for downgrades and negative outlooks: increase by 67 basis points (5.77%) Jaramillo & Tejada 2011 1997-2010, 35 emerging markets, average of S&P, Moody’s, and Fitch
DV: EMBI Global spreads, monthly data
upgrade to investment grade decreases spreads by 35% or 160 basis points (beyond what is implied by macroeconomic factors)
5-10% reduction for investment grade rated
no significant impact for speculative grade rated
Afonso et al. 2011b 1995-2010, EU countries, S&P, Moody’s, Fitch
DV: sovereign bond yields and CDS spreads
negative announcement increases yields by 0.08 (CDS spreads by 0.13 percentage points), a positive
announcements decreases CDS spreads by 0.01 percentage points
stronger impact for: negative announcements Kiff et al. 2012 2005-2010, 72 countries, S&P, Moody’s, Fitch DV: sovereign CDS spreads
stronger impact for: negative credit warnings
upgrades and downgrades in and out of investment grade
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Despite these clear findings, the empirical studies cannot show why bond spreads move in the expected direction following a sovereign rating change. In some cases, sovereign rating changes might coincide with other events driving the bond price changes. Moreover, these studies cannot take into account market expectations of sovereign rating changes. Finally, none of these studies is able to distinguish whether sovereign ratings matter because of their informational or because of their regulatory value. However, two recent studies aim to distinguish between these two effects for corporate bonds. In a sample of US corporate bond issues from 2000-2008, Bongaerts et al. (2012) show that Fitch ratings only matter when they can be the tie-breaker at regulatory thresholds between Moody’s and Standard & Poor’s. Kisgen and Strahan (2009) analyze market reactions in response to the decision by the US Securities and Exchange Commission to recognize Dominion Bond Rating Service as a fourth nationally recognized statistical rating organization. DBRS ratings could only be used for regulatory purposes due to this decision. According to their study, corporate bond yields change in exactly the direction of a company’s rating by Dominion Bond Rating Service, which indicates the importance of rating inclusion in public regulation.
In addition to sovereign ratings’ impact on the rated country, several studies demonstrate that sovereign ratings also have an impact on other countries. Kaminsky and Schmukler (2002) first test for these spillover effects on the bond spreads of other countries for a sample of 16 emerging market economies from 1990-2000. They show that these effects are stronger at the regional level and during crisis episodes. In a sample of 34 developed and developing countries, Gande and Parsley (2005) find that negative rating announcements lead to contagion to other countries. Ismailescu and Kazemi (2010) confirm spillover effects for emerging-market economies’ CDS from 2001-2008 and Arezki et al (2011) for Euro area government CDS from 2007-2010. De Santis (2012) highlights the direct spillovers from downgrades for Greece, Ireland, and Portugal for other Euro area government bond yields. In the most extensive study thus far, Böninghausen and Zabel (2013) confirm earlier results for a sample of 73 developed and emerging market economies for all three CRAs from 1994-2011. Spillovers are generally stronger for downgrades and within the same region.
Beyond its impact on governments bonds, many studies demonstrate that sovereign ratings also have direct impact on the domestic economy. Kaminsky and Schmukler (2002) show that domestic stock market returns decline by about one percentage point
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following a domestic downgrade. Brooks et al. (2004) and Hooper et al. (2008) confirm this result for wider samples. In an extensive sample of 101 countries from 1990-2006, Hill and Faff (2010) highlight that this impact is particularly strong during crisis episodes.
It is not surprising that sovereign ratings influence the valuation and creditworthiness of domestic companies because sovereign ratings often have a direct impact on companies’ ratings. Until the early 2000s, foreign currency ratings served as ceilings for domestic companies’ ratings and since then, the new country ceiling ratings also move in tandem with foreign currency ratings (see above, Fitch 2012a: 5, Gaillard 2012: 24- 25). Fitch demonstrates that about half of its 958 international rating changes of corporate, bank and insurance companies outside of North America can be explained by sovereign rating changes (Fitch 2008: 1). Borensztein et al. (2007) show that sovereign ratings have an impact on companies’ ratings even after controlling for country-specific macroeconomic factors and firm-level variables.
The link between sovereign and companies’ ratings is especially pronounced for domestic banks. The sovereign-bank nexus has become very clear in the European debt crisis (see IMF 2012: 33-34, Mody & Sandri 2012). As bondholders, banks are directly affected by a sovereign rating downgrade. The lower market value of the government bonds held by the bank in turn leads to a higher bailout risk. The need for more bank bailouts increases the sovereign default probability, which also lowers the probability that the sovereign will be able to bailout all insolvent banks. Beyond the European crisis, Williams et al. (2013) find that sovereign ratings also have a direct impact on bank ratings for emerging market countries in their sample of 54 countries from 1999- 2009.
Overall, these empirical findings show the direct impact of sovereign rating changes on government bond prices and the domestic economy. This provides countries with an incentive to closely take into account what rating agencies demand from them.
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