I used to be on a household trip in August 2011 once I acquired an e mail from a journalist asking me what I assumed concerning the S&P rankings downgrade for the US. Since I keep blissfully unaware of most information tales and issues associated to markets when I’m on the seaside, I needed to search for what he was speaking about, and it was S&P’s choice to downgrade america, which had at all times loved AAA, the very best sovereign ranking that may be granted to a rustic, to AA+, reflecting their considerations about each the fiscal challenges confronted by the nation, with mounting commerce and finances deficits, in addition to the willingness of its political establishments to flirt with the potential of default. For greater than a decade, S&P remained the outlier, however in 2023, Fitch joined it by additionally downgrading the US from AAA to AA+, citing the identical causes. That left Moody’s, the third of the main sovereign rankings businesses, as the one one which persevered with a Aaa (Moody’s equal of AAA) for the US, however that modified on Might 16, 2025, when it too downgraded the US from Aaa (destructive) to Aa1 (secure). Because the rankings downgrade occurred after shut of buying and selling on a Friday, there was concern that markets would get up on the next Monday (Might 19) to a wave of promoting, and whereas that didn’t materialize, the remainder of the week was a down week for each shares and US treasury bonds, particularly on the longest finish of the maturity spectrum. Moderately than rehash the arguments about US debt and political dysfunction, which I’m certain that you just had learn elsewhere, I assumed I’d take this second to speak about sovereign default danger, how rankings businesses fee sovereigns, the biases and errors in sovereign rankings and their predictive energy, and use that dialogue as a launching pad to speak about how the US rankings downgrade will have an effect on fairness and bond valuations not simply within the US, however around the globe.
Sovereign Defaults: A Historical past
By means of time, governments have usually been depending on debt to finance themselves, some within the native foreign money and far in a overseas foreign money. A big proportion of sovereign defaults have occurred with overseas foreign money sovereign borrowing, because the borrowing nation finds itself wanting the overseas foreign money to fulfill its obligations. Nevertheless, these defaults, and particularly so lately, have been supplemented by nations which have chosen to default on native foreign money borrowings. I exploit the phrase “chosen” as a result of most nations have the capability to keep away from default on native foreign money debt, with the ability to print cash in that foreign money to repay debt, however selected not to take action, as a result of they feared the results of the inflation that may comply with greater than the results of default.
Whereas the variety of sovereign defaults has ebbed and flowed over time, there are two factors value making concerning the knowledge. The primary is that, over time, sovereign defaults, particularly on overseas foreign money debt, have shifted from financial institution debt to sovereign bonds, with thrice as many sovereign defaults on bonds than on financial institution loans in 2023. The second is that native foreign money defaults are persistent over time, and whereas much less frequent than overseas foreign money defaults, stay a major proportion of whole defaults.
The implications of sovereign default have been each financial and political. Moreover the plain implication that lenders to that authorities lose some or an excessive amount of what’s owed to them, there are different penalties. Researchers who’ve examined the aftermath of default have come to the next conclusions concerning the short-term and long-term results of defaulting on debt:
- Default has a destructive impression on the economic system, with actual GDP dropping between 0.5% and a pair of%, however the bulk of the decline is within the first yr after the default and appears to be quick lived.
- Default does have an effect on a rustic’s long-term sovereign ranking and borrowing prices. One examine of credit score rankings in 1995 discovered that the rankings for nations that had defaulted a minimum of as soon as since 1970 have been one to 2 notches decrease than in any other case related nations that had not defaulted. In the identical vein, defaulting nations have borrowing prices which might be about 0.5 to 1% larger than nations that haven’t defaulted. Right here once more, although, the results of default dissipate over time.
- Sovereign default may cause commerce retaliation. One examine signifies a drop of 8% in bilateral commerce after default, with the results lasting for as much as 15 years, and one other one which makes use of trade degree knowledge finds that export-oriented industries are notably harm by sovereign default.
- Sovereign default could make banking programs extra fragile. A examine of 149 nations between 1975 and 2000 signifies that the chance of a banking disaster is 14% in nations which have defaulted, an eleven percentage-point enhance over non-defaulting nations.
- Sovereign default additionally will increase the chance of political change. Whereas not one of the research concentrate on defaults per se, there are a number of which have examined the after-effects of sharp devaluations, which frequently accompany default. A examine of devaluations between 1971 and 2003 finds a forty five% enhance within the chance of change within the prime chief (prime minister or president) within the nation and a 64% enhance within the chance of change within the finance govt (minister of finance or head of central financial institution).
In abstract, default is expensive, and nations don’t (and shouldn’t) take the potential of default calmly. Default is especially costly when it results in banking crises and foreign money devaluations; the previous has a longstanding impression on the capability of corporations to fund their investments whereas the latter create political and institutional instability that lasts for lengthy durations.
Sovereign Scores: Measures and Course of
Since few of us have the sources or the time to dedicate to understanding small and unfamiliar nations, it’s no shock that third events have stepped into the breach, with their assessments of sovereign default danger. Of those third-party assessors, bond rankings businesses got here in with the largest benefits:
- They’ve been assessing default danger in firms for 100 years or extra and presumably can switch a few of their expertise to assessing sovereign danger.
- Bond traders who’re acquainted with the rankings measures, from investing in company bonds, discover it simple to increase their use to assessing sovereign bonds. Thus, a AAA rated nation is considered as near riskless whereas a C rated nation may be very dangerous.
Moody’s, Customary and Poor’s and Fitch’s have been ranking company bond choices for the reason that early a part of the 20th century. Moody’s has been ranking company bonds since 1919 and began ranking authorities bonds within the Nineteen Twenties, when that market was an lively one. By 1929, Moody’s supplied rankings for nearly fifty central governments. With the Nice Melancholy and the Second World Struggle, investments in authorities bonds abated and with it, the curiosity in authorities bond rankings. Within the Nineteen Seventies, the enterprise picked up once more slowly. As lately because the early Eighties, solely about 13 governments, largely in developed and mature markets, had rankings, with most of them commanding the very best degree (Aaa). The last decade from 1985 to 1994 added 34 nations to the sovereign ranking record, with lots of them having speculative or decrease rankings and by 2024, Moody’s alone was ranking 143 nations, protecting 75% of all rising market nations and nearly each developed market.
Not solely have rankings businesses turn out to be extra lively in including nations to their rankings record, however they’ve additionally expanded their protection of nations with extra default danger/ decrease rankings. The truth is, the variety of Aaa rated nations was the identical in 1985, when there have been 13 rated nations, as in 2025, when there have been 143 rated nations. Within the final twenty years, a minimum of 5 sovereigns, together with Japan, the UK, France and now the US, have misplaced their Aaa rankings. Along with extra nations being rated, the rankings themselves have turn out to be richer. Moody’s and S&P now present two rankings for every nation – an area foreign money ranking (for home foreign money debt/ bonds) and a overseas foreign money ranking (for presidency borrowings in a overseas foreign money).
In assessing these sovereign rankings, rankings businesses draw on a large number of information, quantitative and qualitative. Moody’s describes its sovereign rankings course of within the image beneath:
The method is broad sufficient to cowl each political and financial components, whereas preserving wiggle room for the rankings businesses to make subjective judgments on default that may result in totally different rankings for 2 nations with related financial and political profiles. The warmth map beneath supplies the sovereign rankings, from Moody’s, for all rated nations the beginning of 2025:
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| Moody’s sovereign rankings |
Notice that the greyed out nations are unrated, with Russia being probably the most vital instance; the rankings businesses withdrew their ranking for Russia in 2022 and never reinstated it but. There have been solely a handful of Aaa rated nations, concentrated in North America (United States and Canada), Northern Europe (Germany, Scandinavia), Australia & New Zealand and Singapore (the one Aaa-rated Asian nation. In 2025, there have been a eight sovereign rankings adjustments, 4 upgrades and 4 downgrades, with the US downgrade from Aaa to Aa1 as the very best profile change
With the US downgrade, the record of Aaa-rated nations has turn out to be shorter, and as Canada and Germany wrestle with finances imbalances, the chances are high that extra firms will drop off the record.
Sovereign Scores: Efficiency and Options
If sovereign rankings are designed to measure publicity to default danger, how properly do they do? The reply is dependent upon the way you consider their efficiency. The rankings businesses present tables that record defaults by ranking that again the proposition that sovereign rankings and default are extremely correlated. A Moody’s replace of default charges by sovereign rankings lessons, between 1983 and 2024, yielded the next:
Default charges rise as sovereign rankings decline, with a default fee of 24% for speculative grade sovereign debt (Baa2 and beneath) versus 1.8% for funding grade (Aaa to Baa1) sovereign debt.
That stated, there are elements of sovereign rankings that ought to give pause to anybody contemplating utilizing them as their proxy for sovereign default, they do include caveats and limitations:
- Scores are upward biased: Scores businesses have been accused by a few of being far too optimistic of their assessments of each company and sovereign rankings. Whereas the battle of curiosity of getting issuers pay for the ranking is obtainable because the rationale for the upward bias in company rankings, that argument doesn’t maintain up with regards to sovereign rankings, since not solely are the revenues small, relative to popularity loss, however a proportion of sovereigns are rated for no charges.
- There may be herd conduct: When one rankings company lowers or raises a sovereign ranking, different rankings businesses appear to comply with go well with. This herd conduct reduces the worth of getting three separate rankings businesses, since their assessments of sovereign danger are not unbiased.
- Too little, too late: To cost sovereign bonds (or set rates of interest on sovereign loans), traders (banks) want assessments of default danger which might be up to date and well timed. It has lengthy been argued that rankings businesses take too lengthy to vary rankings, and that these adjustments occur too late to guard traders from a disaster.
- Vicious Cycle: As soon as a market is in disaster, there’s the notion that rankings businesses generally overreact and decrease rankings an excessive amount of, thus making a suggestions impact that makes the disaster worse. That is very true for small nations which might be largely depending on overseas capital for his or her funds.
- Regional biases: There are various, particularly in Asia and Latin America, that consider that the rankings businesses are too lax in assessing default danger for North America and Europe, overrating nations in these areas, whereas being too stringent of their assessments of default in Asia, Latin America and Africa, underrating nations in these areas.
In sum, the proof means that whereas sovereign rankings are good measures of nation default danger, adjustments in rankings usually lag adjustments on the bottom, making them much less helpful to lenders and traders.
If the important thing limitation of sovereign rankings is that they aren’t well timed assessors of nation default danger, that failure is alleviated by the event of the sovereign CDS market, a market the place traders can purchase insurance coverage towards nation default danger by paying an (annualized) worth. Whereas that market nonetheless has points when it comes to counterparty danger and authorized questions on what includes default, it has expanded within the final twenty years, and in the beginning of 2025, there have been about 80 nations with sovereign CDS out there on them. The warmth map beneath supplies an image of sovereign (10-year) CDS spreads on January 1, 2025:
As you possibly can see, even in the beginning of 2025, the market was drawing a distinction between the most secure Aaa-rated nations (Scandinavia, Switzerland, Australia and New Zealand), all with sovereign CDS spreads of 0.20% or beneath, and extra dangerous Aaa-rated nations (US, Germany, Canada). Throughout 2025, the market shocks from tariff and commerce wars have had an impact, with sovereign CDS spreads growing, particularly in April. The US, which began 2025 with a sovereign CDS unfold of 0.41%, noticed a widening of the unfold to 0.62% in late April, earlier than dropping again a bit in Might, with the Moody’s downgrade having nearly no impact on the US sovereign CDS unfold.
The US Downgrade: Lead-in and Aftermath
With that background on sovereign default and rankings, let’s check out the story of the second, which is the Moody’s downgrade of the US from Aaa to Aa1. Within the weeks since, we’ve not seen a serious upheaval in markets, and the query that we face as traders and analysts is whether or not something of consequence has modified on account of the downgrade.
The Lead-in
As I famous in the beginning of this publish, Moody’s was the final of the massive three sovereign rankings businesses giving america a Aaa ranking, with S&P (in 2011) and Fitch (in 2023) having already downgraded the US. The truth is, the 2 causes that each rankings businesses supplied on the time of their downgrades have been rising authorities debt and politically dysfunction have been additionally the explanations that Moody’s famous of their downgrade. On the debt entrance, one of many measures that rankings businesses use to evaluate a rustic’s monetary standing is its debt to GDP ratio, and it’s simple that this statistic has trended upwards for america:
The ramping up of US debt since 2008 is mirrored in whole federal debt rising from 80% of GDP in 2008 to greater than 120% in 2024. Whereas a number of the surge in debt will be attributed to the exigencies attributable to crises (the 2008 banking disaster and the 2020 COVID bailouts), the troubling fact is that the debt has outlasted the crises and blaming the crises for the debt ranges as we speak is disingenuous.
The issue with the debt-to-GDP measure of sovereign fiscal standing is that it’s an imperfect indicator, as will be seen on this record of nations that scored highest and lowest on this measure in 2023:
Lots of the nations with the very best debt to GDP ratios can be categorised as protected and a few have Aaa rankings, whereas only a few of the nations on the bottom debt to GDP record would qualify as protected. Even when it it the excessive debt to GDP ratio for the US that triggered the Moody’s downgrade, the query is why Moody’s selected to do that in 2025 fairly than a yr or two or perhaps a decade in the past, and the reply to that lies, I feel, within the political element. A sovereign default has each financial and political roots, since a authorities that’s intent on preserving its credit score standing will usually discover methods to pay its debt and keep away from default. For many years now, the US has loved particular standing with markets and establishments (like rankings businesses), constructed as a lot on its institutional stability (authorized and regulatory) because it was on its financial energy. The Moody’s downgrade appears to me a sign that these days could be winding down, and that america, like the remainder of the world, will face extra accountability for lack of self-discipline in its fiscal and financial coverage.
Market Response
The rankings downgrade was after shut of buying and selling on Friday, Might 16, and there was concern about how it might play out in markets, after they opened on Monday, Might 19. US equities have been really up on that day, although they misplaced floor within the subsequent days:
If fairness markets have been comparatively unscathed within the two weeks after the downgrade, what about bond markets, and specifically, the US treasury market? In any case, an issuer downgrade for any bond is dangerous information, and charges ought to be anticipated to rise to mirror larger default danger:
Whereas charges did go up within the the primary few days after the downgrade, the impact was muddled by the passage of a reconciliation invoice in the home that probably might add to the deficit in future years. The truth is, by the Might 29, 2025, nearly all the downgrade impact had pale, with charges near the place they have been in the beginning of the yr.
You could be stunned that markets didn’t react extra negatively to the rankings downgrade, however I’m not for 3 causes:
- Lack of shock impact: Whereas the timing of the Moody’s downgrade was sudden, the downgrade itself was not shocking for 2 causes. First, since S&P and Fitch had already downgraded the US, Moody’s was the outlier in giving the US a Aaa ranking, and it was solely a matter of time earlier than it joined the opposite two businesses. Second, along with reporting a sovereign ranking, Moody’s discloses when it places a rustic on a look ahead to a rankings adjustments, with constructive (destructive) indicating the potential of a rankings improve (downgrade). Moody’s modified its outlook for the US to destructive in November 2023, and whereas the ranking remained unchanged till Might 2025, it was clearly contemplating the downgrade within the months main as much as it.
- Magnitude of personal capital: The rapid impact of a sovereign rankings downgrade is on authorities borrowing, and whereas the US does borrow huge quantities, personal capital (within the type of fairness and debt) is a far larger supply of financing and funding for the economic system.
- Scores change: The rankings downgrade ws extra of a blow to satisfaction than to funds, for the reason that default danger (and default unfold) distinction between an Aaa ranking and a Aa1 ranking is small. Austria and Finland, for example, had Aa1 rankings in Might 2025, and their ten-year bonds, denominated in Euros, traded at a ramification of about 0.15- 0.20% over the German ten-year Euro bond; Germany had a Aaa ranking.
Penalties for valuation and funding evaluation
Whereas the rapid financial and monetary penalties of a downgrade from Aaa to Aa1 shall be small, there are implications for analysts around the globe. Particularly, analysts should take steps when working with US {dollars} that they could already be taking already when working with most different currencies in estimating primary inputs into monetary evaluation.
Let’s begin with the riskfree fee, a primary constructing block for estimating prices of fairness and capital, that are inputs into intrinsic valuation. In precept, the riskfree fee is what you’ll earn on a assured funding in a foreign money, and any danger premiums, both for investing in fairness (fairness danger premium) or in fastened revenue securities (default spreads), are added to the riskfree fee. It’s commonplace apply in lots of textbooks and lecture rooms to make use of the federal government bond fee as the danger free fee, however that’s constructed on the presumption that governments can’t default (a minimum of on bonds issued within the native foreign money). Utilizing a Aaa (AAA) ranking as a (lazy) proxy for default-free, that’s the rationale we used to justify authorities bond charges as riskfree charges in the beginning of 2025, in Australian, Singapore and Canadian {dollars}, the Euro (Germany). Swiss francs and Danish krone. As we famous within the first part, the idea that governments do not default is violated in apply, since some nations select to default on native foreign money bonds, fairly than resist inflation. If that’s the case, the federal government bond fee is not really a riskfree fee, and attending to a riskfree fee would require netting out a default unfold from the federal government bond fee:
Danger free fee = Authorities Bond fee − Default unfold for the federal government
The default unfold will be estimated both from the sovereign bond ranking (with a glance up desk) or a sovereign CDS unfold, and we used that course of to get riskfree in charges in a host of currencies, the place native foreign money authorities bonds had default danger, in the beginning of 2025:
Thus, to get a riskfree fee in Indian rupees, Brazilian reals or Turkish lira, we begin with authorities bonds in these currencies and internet out the default spreads for the nations in query. We do that to make sure that we do not double depend nation danger by first utilizing the federal government bond (which incorporates default danger) as a riskfree fee after which utilizing a bigger fairness danger premium to permit for a similar nation danger.
Now that the US is not Aaa rated, we’ve to comply with an analogous course of to get a riskfree fee in US {dollars}:
- US 10-year treasury bond fee on Might 30, 2025 = 4.41%
- Default unfold based mostly on Aa1 ranking on Might 30, 2025 = 0.40%
- Riskfree fee in US {dollars} on Might 30, 2025 = US 10-year treasury fee – Aa1 default unfold = 4.41% – 0.40% = 4.01%
This adjustment yields a riskfree fee of 4.01% in US {dollars}, and it’s also constructed on the presumption that the default unfold manifested after the Moody’s downgrade on Might 16, when the extra real looking studying is that US treasury markets have been carrying a default unfold embedded in them for years, and that we do not make it express.
The rankings downgrade for the US may also have an effect on the fairness danger premium computations that I exploit to estimate the price of fairness for firms. As a few of you who observe my fairness danger premiums by nation know, I estimate an fairness danger premium for the S&P 500, and a minimum of till the beginning of this yr, I used that as a premium for all mature markets (with a AAA (Aaa) ranking because the indicator of maturity). Thus, nations like Canada, Germany, Australia and Singapore have been all assigned the identical premium as that attributed to the S&P 500. For nations with rankings beneath Aaa, I added an “additional nation danger premium” computed based mostly upon the default spreads that went with the nation rankings:
With the rankings downgrade, I should modify this course of in 3 ways. The primary is that when computing the fairness danger premium for the S& P 500, I should internet out the adjusted riskfree fee in US {dollars} fairly than the US treasury fee, yielding the next fairness danger premium for the US. Second, for Aaa rated nations, to the extent that they’re safer than the US will must be assigned an fairness danger premium decrease than the US, with the adjustment downward reflecting the Aa1 ranking for the US. The third is that for all different nations, the country danger premium shall be computed based mostly upon the the their default spreads and the fairness danger premium estimated for Aaa rated nations (fairly than the US fairness danger premium):
How will the price of fairness for a agency with all of its revenues in america be affected as a consequence? Let’s take three firms, one below-average danger, one average-risk and one above common danger, and compute their prices of fairness on Might 30, 2025, with and with out the downgrade favored in:
As you possibly can see, the anticipated return on the S&P 500 as of Might 30, 2025, reflecting the index degree then and the anticipated money flows, is 8.64%. Incorporating the results of the downgrade adjustments the composition of that anticipated return, leading to a decrease riskfree fee (4.01% as an alternative of 4.41%) and the next fairness danger premium (4.63% as an alternative of 4.23%). Thus, whereas the anticipated return for the common inventory stays at 8.64%, the anticipated return will increase barely for riskier shares and reduces barely for safer shares, however the results are so small that traders will hardly discover. If there’s a lesson for analysts right here, it’s that the downgrade’s results on the low cost charges (prices of fairness and capital) are minimal, and that staying with the standard method (of utilizing the ten-year US treasury bond fee because the riskfree fee and utilizing that fee to compute the fairness danger premium) will proceed to work.
Conclusion
The Moody’s rankings downgrade of the US made the information, and far was product of it through the weekend that adopted. The monetary and financial penalties, a minimum of up to now, have been inconsequential, with fairness and bond markets shrugging off the downgrade, maybe as a result of the shock issue was minimal. The downgrade additionally has had solely a minimal impression on prices of fairness and capital for US firms, and whereas which will change, the adjustments will come from macroeconomic information or from crises. For probably the most half, analysts ought to have the ability to proceed to work with the US treasury fee as a riskfree fee and forward-looking fairness danger premiums, as they did earlier than the downgrade. With all of that stated, although, the Moody’s motion does carry symbolic weight, one other indicator that US exceptionalism, which allowed the US to take financial and monetary actions that may have introduced blowback for different nations, particularly in rising markets, is coming to an finish. That’s wholesome, in the long run, for each america and the remainder of the world, however it should include quick time period ache.
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