Boom and Bust and Sovereign Ratings

France joined Austria in losing its top credit rating after government-bond markets closed last week, on Friday 13(!) January.The nations were cut one level to AA+ from AAA and face the risk of further reductions, according to Standard and Poor's, with Moody's and Fitch the world's leading rating agency. While Finland, the Netherlands and Luxembourg kept their AAA ratings, they were put on negative outlook. Spain and Italy were also among the nations downgraded and Portugal was cut two steps to BB. However, on Monday 16 January, French bonds advanced as borrowing costs fell at the nation’s first debt sale since Standard & Poor’s stripped it of its top credit rating and cut the grades of eight other euro-area countries. So what to expect for sovereign risk spreads of the downgraded Europeans against German sovereign risk, holding the euro region’s only stable AAA grade? Further widening, I am afraid.

For what it's worth, let's consult a paper that I wrote with Julia von Maltzan in 1999*, a rating event study exploring the market response for 30 trading days before and after rating announcements. The Figure shows the mean of relative yield spreads before and after 103 rating events. 

In general, the Figure conveys that a change in the risk assessment by the three leading rating agencies is preceded by a similar change in the market’s assessment of sovereign risk. The pattern is particularly clear when countries have been put on review for possible downgrade or upgrade. During the 29 days preceding a review for possible downgrade, relative spreads rise by about 12 percentage points.

For the Euro countries down graded before the weekend another of our result augurs badly, notwithstanding France's successful bond auction today:  Implemented negative rating changes seem to exert a sustained impact on bond yield spreads: the rating downgrade is largely unanticipated. After a country’s rating has been downgraded, the market appears to vindicate the agencies’ assessment over the next 30 trading days with an upward movement in relative yield spreads.

Implement downgrades of emerging-market bonds were shown in our study to produce a strongly significant market reaction: During 30 trading days, from ten days before the press release issued by the rating agency to 20 days thereafter, relative yield spreads widen significantly by an accumulated 12.7 percentage points.

* Helmut Reisen and Julia von Maltzan (1999), "Boom and Bust and Sovereign Ratings", International Finance, Vol.2:2, pp.273-293.