Sovereign ratings and sovereign bond yields do not capture identical risks so investors should not necessarily expect a rating action to always lead to a significant change in bond yields, according to Fitch Ratings.
In its report, entitled
‘Why Sovereign Rating Actions Have a Variable Impact on Bond Yields’
, the credit ratings agency (CRA) says that its ratings are a measure of the relative rank ordering of credit (i.e. default) risk, while bond yields reflect a broader mix of fundamental factors such as policy interest rates, inflation and exchange rate expectations as well as market liquidity and risk appetite conditions. Lower sovereign bond yield in Japan than the US are not purely an indicator of credit risk.
Fitch seeks to use rating outlooks and watches and its commentary to transparently signal the likelihood and triggers of rating upgrades and downgrades. Therefore by the time of the action, the upgrade or downgrade is less of a surprise to the market and its information content will likely already be at least partly reflected in the market price.
International Monetary Fund (IMF), European Central Bank (ECB) and other studies show that rating and outlook changes do have a significant impact on bond yields and other market prices, contrary to some market commentary. Nonetheless they do not always do so, for reasons explored in the report.
Credit spreads should, in theory, reflect the compensation that investors demand for expected credit loss, which is the product of default risk and loss given default. However, bond yields can also reflect factors not related to credit fundamentals, including global liquidity conditions and risk sentiment. In addition, many investors have a total return trading orientation focusing on shorter term changes in the mark-to-market value of their bonds, rather than on a longer term horizon of fundamental credit risk.
Financial market prices change more frequently than ratings and are often but not always faster to pick up a change in creditworthiness. However markets also have a tendency to overshoot and can create false signals of changes in fundamentals before reverting to prior levels.
Bond yields may also be influenced by central bank operations (such as quantitative easing), by government or regulators changing liquidity requirements or risk weighting of assets, by clearing houses changing collateral requirements, or by inclusion or exclusion in bond indices.
For high-grade benchmark sovereigns, credit risk is a less powerful determinant of bond yields than inflation and interest rates, so changes in ratings and/or credit risk would be expected to have a moderate impact on the total yield. It is possible that a downgrade of a benchmark sovereign such as the US could have a counterintuitive effect of lowering the yield if it were accompanied by a ‘flight to safety’ into assets generally viewed as a safe haven.
Fitch adds that it publishes regular sovereign default and transition studies which show a strong relationship between its sovereign ratings and the frequency of default. External studies, including by the IMF, corroborate the finding that ratings capture the rank ordering of default risk among sovereigns.
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