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Standard & Poor’s recent credit rating downgrade of nine Eurozone nations may have been treated as a big deal by the media, but for financial markets, the “news” was already in the price.
In fact, the market reaction to S&P’s lowering of the sovereign debt ratings of France, Austria, Malta, Slovakia, Slovenia, Italy, Spain, Portugal, and Cyprus has provided another timely reminder of how markets work.
This is not to downplay real concerns about the huge liabilities amassed by sovereign borrowers and the hardships being borne by their populations due to the profligate lending and borrowing of banks and governments.
But it is worth keeping in mind that, by the time the ratings agencies get around to registering their official disapproval, the market has already done the worrying for you. This really shouldn’t be a surprise, as the rating agencies work from the same information available to the market in aggregate.
As an example, let’s look at how the sovereign debt markets moved before and after the announcement by S&P on January 13. In this example, we look at the movements of bonds in three of the downgraded countries—France, Austria, and Spain—relative to those of Germany in the week prior and following the downgrade.
Germany is used as the benchmark here because it is perceived as the most secure sovereign borrower within Europe—the “risk-free” rate, if you like. By the way, the “spread” is the margin that investors demand for the additional risk of investing in France, Austrian, and Spanish bonds over German bonds.
What the tables below show is that these spreads all “tightened”—the peripheral bonds rallied in relation to German bonds—in both the week prior to the downgrade and the week afterward.
The third table shows what happened to spreads in the full two weeks surrounding the S&P ratings announcement. You can see that spreads of all three sovereigns narrowed in that period. Put another way, their prices rose more than comparable-maturity German debt. That means those bonds produced positive returns during what was widely portrayed in the media as a ratings “shock.”
The second set of three tables details those positive total returns relative to comparable maturity German bonds in the three periods.
Markets vs. Ratings Agencies, Round 1:
Change in Yield Spreads Relative to Comparable Maturity German Debt
January 6–13: Before the downgrades:
| Maturity | France | Austria | Spain |
|---|---|---|---|
| 2 | –0.302 | –0.507 | –0.706 |
| 5 | –0.370 | –0.464 | –0.734 |
| 10 | –0.291 | –0.373 | –0.484 |
| 30 | –0.239 | –0.245 | –0.194 |
January 13–20: After the downgrades:
| Maturity | France | Austria | Spain |
|---|---|---|---|
| 2 | 0.266 | –0.030 | 0.266 |
| 5 | –0.035 | –0.119 | –0.035 |
| 10 | 0.263 | 0.060 | 0.263 |
| 30 | 0.017 | 0.122 | 0.017 |
January 6–20: Two weeks around the downgrades:
| Maturity | France | Austria | Spain |
|---|---|---|---|
| 2 | –0.210 | –0.537 | –0.440 |
| 5 | –0.429 | –0.583 | –0.769 |
| 10 | –0.277 | –0.313 | –0.221 |
| 30 | –0.182 | –0.123 | –0.177 |
Source: Bloomberg.
Markets vs. Ratings Agencies, Round 2
Sovereign Incremental Total Returns vs. Germany1
January 6–13: Before the downgrades:
| Maturity | France | Austria | Spain |
|---|---|---|---|
| 1–5 Year | 0.67 | 0.90 | 1.75 |
| 5–10 Year | 1.32 | 1.99 | 2.91 |
| 10+ Year | 1.94 | 1.68 | 1.39 |
January 13–20: After the downgrades:
| Maturity | France | Austria | Spain |
|---|---|---|---|
| 1–5 Year | 0.50 | 0.71 | 0.27 |
| 5–10 Year | 1.46 | 1.15 | 1.10 |
| 10+ Year | 2.10 | 1.44 | 2.41 |
January 6–20: Two weeks around the downgrades:
| Maturity | France | Austria | Spain |
|---|---|---|---|
| 1–5 Year | 1.17 | 1.61 | 2.01 |
| 5–10 Year | 2.91 | 3.27 | 4.13 |
| 10+ Year | 4.07 | 3.14 | 3.84 |
Source: Bank of America Merrill Lynch Indices. Indices are not available for direct investment.
Markets vs. Ratings Agencies, Round 3
Credit Default Swaps as a Market Signal
Another way of looking at the superiority of market pricing as a signal of sovereign risk is to look at credit default swaps, or “CDSs.” These derivative instruments are a form of insurance policy that some investors take out against a loan default. There are CDSs for corporate borrowers and for sovereign borrowers. Broadly speaking, the higher the price of default insurance for each sovereign borrower, the greater the market sees as the risk of investors not getting their money back.
The very liquid market for CDSs is a useful guide to how the market views the relative risk of default among various sovereign borrowers. And it is clear that risk judged by the market and risk judged by credit rating agencies are not necessarily the same.
So until January 13 this year, Germany, France, and Austria were all assigned by Standard & Poor’s highest rating, AAA, reserved for borrowers deemed the most creditworthy. Spain was rated AA- (and was downgraded to A).
But the chart below, showing historical credit default swaps for Germany, France, Austria, and Spain, demonstrates that the market was pushing up the price of insurance on French, Austrian, and Spanish bonds well ahead of the downgrades.
In fact, by last November, the perceived risk of French and Austrian bonds relative to German bonds was seen as significantly greater, despite all three countries being nominally AAA rated borrowers. In other words, France and Austria were behaving more like AA bonds well before the downgrade.
Furthermore, the insurance on default was actually falling in the week before the downgrade, which shows once again how markets move ahead of the agencies.
Why would the market view France and Austria as presenting a greater sovereign risk than Germany despite all three countries sharing the same credit rating? Clearly, the market was working off contemporaneous information. The debt crisis was moving at such a pace that the news was running ahead of the official rating. In the case of France and Austria, they were perceived as having less flexibility than Germany in raising new loans and rolling over existing ones.
As an aside, some investors who are skeptical about the ratings agencies might seek to rely on macroeconomic signals such as a country’s public debt-to-GDP ratio, but as we showed in the previous edition of our sovereign risk analysis, these numbers are no more a reliable indicator of risk than credit ratings.
Japan, for instance, has the highest debt-to-GDP ratio in the developed world—at around 200 percent (even more than Greece)—yet it maintains a AA- credit rating against the junk status of Greece. Australia, with the lowest debt in the OECD, has a AAA rating from S&P, yet in the CDS market, it is rated a greater risk than the AA+ rated US, which has the advantage of being able to borrow in its own currency.
So which offers the best signal: the credit rating agencies, the economic fundamentals or the market? The answer to that question is that no one knows for sure, because no one has found a way to correctly and reliably forecast the future.
But in pricing risk, it is usually better to give greater weight to market signals—if for no other reason than the price represents the combined wisdom of millions of market participants staking real money on the outcome.
Markets incorporate all these pieces of information—economic variables, credit ratings, risk perceptions, willingness to pay—and put a price on them.
And that is why, in Dimensional’s case, our first point of reference is always the market itself, not economic variables or the credit rating agencies.
1. Incremental total return for a specific country and maturity range is defined as the total return of the country and maturity range minus the total return of the corresponding German maturity range.
