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I used to be on a household trip in August 2011 after I obtained an electronic mail from a journalist asking me what I believed in regards to 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 resolution to downgrade the USA, which had all the time loved AAA, the very best sovereign ranking that may be granted to a rustic, to AA+, reflecting their issues about each the fiscal challenges confronted by the nation, with mounting commerce and funds 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 companies, as the one one which continued with a Aaa (Moody’s equal of AAA) for the US, however that modified on Could 16, 2025, when it too downgraded the US from Aaa (detrimental) to Aa1 (steady). 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 (Could 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. Quite than rehash the arguments about US debt and political dysfunction, which I’m positive that you just had learn elsewhere, I believed I might take this second to speak about sovereign default danger, how rankings companies charge 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 all over the world.
Sovereign Defaults: A Historical past
By means of time, governments have typically been depending on debt to finance themselves, some within the native foreign money and far in a international foreign money. A big proportion of sovereign defaults have occurred with international foreign money sovereign borrowing, because the borrowing nation finds itself wanting the international foreign money to satisfy its obligations. Nevertheless, these defaults, and particularly so lately, have been supplemented by international locations which have chosen to default on native foreign money borrowings. I take advantage of the phrase “chosen” as a result of most international locations have the capability to keep away from default on native foreign money debt, having 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 will comply with greater than the results of default.
Whereas the variety of sovereign defaults has ebbed and flowed over time, there are two factors price making in regards to the information. The primary is that, over time, sovereign defaults, particularly on international 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 international foreign money defaults, stay a major proportion of whole defaults.
The implications of sovereign default have been each financial and political. Apart from the plain implication that lenders to that authorities lose some or quite a lot of what’s owed to them, there are different penalties. Researchers who’ve examined the aftermath of default have come to the next conclusions in regards to the short-term and long-term results of defaulting on debt:
- Default has a detrimental affect on the financial 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 brief 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 international locations that had defaulted no less than as soon as since 1970 had been one to 2 notches decrease than in any other case comparable international locations that had not defaulted. In the identical vein, defaulting international locations have borrowing prices which might be about 0.5 to 1% greater than international locations that haven’t defaulted. Right here once more, although, the consequences of default dissipate over time.
- Sovereign default could cause commerce retaliation. One examine signifies a drop of 8% in bilateral commerce after default, with the consequences lasting for as much as 15 years, and one other one which makes use of trade stage information finds that export-oriented industries are significantly damage by sovereign default.
- Sovereign default could make banking methods extra fragile. A examine of 149 international locations between 1975 and 2000 signifies that the chance of a banking disaster is 14% in international locations which have defaulted, an eleven percentage-point enhance over non-defaulting international locations.
- Sovereign default additionally will increase the probability of political change. Whereas not one of the research deal with defaults per se, there are a number of which have examined the after-effects of sharp devaluations, which regularly 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 international locations don’t (and mustn’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 affect on the capability of companies 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 assets or the time to dedicate to understanding small and unfamiliar international locations, 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 companies got here in with the largest benefits:
- They’ve been assessing default danger in companies for 100 years or extra and presumably can switch a few of their expertise to assessing sovereign danger.
- Bond traders who’re aware of the rankings measures, from investing in company bonds, discover it straightforward to increase their use to assessing sovereign bonds. Thus, a AAA rated nation is seen as near riskless whereas a C rated nation could be very dangerous.
Moody’s, Customary and Poor’s and Fitch’s have been ranking company bond choices because the early a part of the 20 th century. Moody’s has been ranking company bonds since 1919 and began ranking authorities bonds within the Twenties, when that market was an lively one. By 1929, Moody’s offered rankings for nearly fifty central governments. With the Nice Despair and the Second World Warfare, 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 just lately because the early Eighties, solely about 13 governments, principally in developed and mature markets, had rankings, with most of them commanding the very best stage (Aaa). The last decade from 1985 to 1994 added 34 international locations to the sovereign ranking checklist, with a lot of them having speculative or decrease rankings and by 2024, Moody’s alone was ranking 143 international locations, masking 75% of all rising market international locations and virtually each developed market.
Not solely have rankings companies turn out to be extra lively in including international locations to their rankings checklist, however they’ve additionally expanded their protection of nations with extra default danger/ decrease rankings. In truth, the variety of Aaa rated international locations was the identical in 1985, when there have been 13 rated international locations, as in 2025, when there have been 143 rated international locations. Within the final 20 years, no less than 5 sovereigns, together with Japan, the UK, France and now the US, have misplaced their Aaa rankings. Along with extra international locations 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 international foreign money ranking (for presidency borrowings in a international foreign money).
In assessing these sovereign rankings, rankings companies draw on a large number of knowledge, quantitative and qualitative. Moody’s describes its sovereign rankings course of within the image under:
The method is broad sufficient to cowl each political and financial components, whereas preserving wiggle room for the rankings companies to make subjective judgments on default that may result in totally different rankings for 2 international locations with comparable financial and political profiles. The warmth map under gives the sovereign rankings, from Moody’s, for all rated international locations the beginning of 2025:
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| Moody’s sovereign rankings |
Notice that the greyed out international locations are unrated, with Russia being probably the most vital instance; the rankings companies withdrew their ranking for Russia in 2022 and never reinstated it but. There have been solely a handful of Aaa rated international locations, 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 modifications, 4 upgrades and 4 downgrades, with the US downgrade from Aaa to Aa1 as the very best profile change
With the US downgrade, the checklist of Aaa-rated international locations has turn out to be shorter, and as Canada and Germany wrestle with funds imbalances, the chances are high that extra international locations will drop off the checklist.
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 companies present tables that checklist 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 charge of 24% for speculative grade sovereign debt (Baa2 and under) versus 1.8% for funding grade (Aaa to Baa1) sovereign debt.
That mentioned, there are features 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 companies 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 on the subject of sovereign rankings, since not solely are the revenues small, relative to status loss, however a proportion of sovereigns are rated for no charges.
- There may be herd habits: When one rankings company lowers or raises a sovereign ranking, different rankings companies appear to comply with go well with. This herd habits reduces the worth of getting three separate rankings companies, since their assessments of sovereign danger are not impartial.
- 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 companies take too lengthy to vary rankings, and that these modifications occur too late to guard traders from a disaster.
- Vicious Cycle: As soon as a market is in disaster, there may be the notion that rankings companies typically overreact and decrease rankings an excessive amount of, thus making a suggestions impact that makes the disaster worse. That is very true for small international locations which might be principally depending on international capital for his or her funds.
- Regional biases: There are a lot of, particularly in Asia and Latin America, that imagine that the rankings companies are too lax in assessing default danger for North America and Europe, overrating international locations in these areas, whereas being too stringent of their assessments of default in Asia, Latin America and Africa, underrating international locations in these areas.
In sum, the proof means that whereas sovereign rankings are good measures of nation default danger, modifications in rankings typically lag modifications 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 should buy insurance coverage in opposition to 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 20 years, and at first of 2025, there have been about 80 international locations with sovereign CDS accessible on them. The warmth map under gives an image of sovereign (10-year) CDS spreads on January 1, 2025:
As you’ll be able to see, even at first of 2025, the market was drawing a distinction between the most secure Aaa-rated international locations (Scandinavia, Switzerland, Australia and New Zealand), all with sovereign CDS spreads of 0.20% or under, and extra dangerous Aaa-rated international locations (US, Germany, Canada). Throughout 2025, the market shocks from tariff and commerce wars have had an impact, with sovereign CDS spreads rising, 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 Could, with the Moody’s downgrade having virtually 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, now we have not seen a significant 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 at first of this submit, Moody’s was the final of the massive three sovereign rankings companies giving the USA a Aaa ranking, with S&P (in 2011) and Fitch (in 2023) having already downgraded the US. In truth, the 2 causes that each rankings companies offered on the time of their downgrades had been rising authorities debt and politically dysfunction had been additionally the explanations that Moody’s famous of their downgrade. On the debt entrance, one of many measures that rankings companies 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 the USA:
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 may 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 right now is disingenuous.
The issue with the debt-to-GDP measure of sovereign fiscal standing is that it’s an imperfect indicator, as may be seen on this checklist of nations that scored highest and lowest on this measure in 2023:
Most of the international locations with the very best debt to GDP ratios could be labeled as protected and a few have Aaa rankings, whereas only a few of the international locations on the bottom debt to GDP checklist 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 somewhat than a yr or two or perhaps a decade in the past, and the reply to that lies, I believe, within the political part. A sovereign default has each financial and political roots, since a authorities that’s intent on preserving its credit score standing will typically 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 companies), 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 is perhaps winding down, and that the USA, 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, Could 16, and there was concern about how it might play out in markets, once they opened on Monday, Could 19. US equities had been truly up on that day, although they misplaced floor within the subsequent days:
If fairness markets had been comparatively unscathed within the two weeks after the downgrade, what about bond markets, and specifically, the US treasury market? In spite of everything, an issuer downgrade for any bond is dangerous information, and charges ought to be anticipated to rise to replicate greater 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 doubtlessly may add to the deficit in future years. In truth, by the Could 29, 2025, virtually all the downgrade impact had pale, with charges near the place they had been at first of the yr.
Chances are you’ll be shocked 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 surprising, 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 companies. Second, along with reporting a sovereign ranking, Moody’s discloses when it places a rustic on a look ahead to a rankings modifications, with optimistic (detrimental) indicating the potential of a rankings improve (downgrade). Moody’s modified its outlook for the US to detrimental in November 2023, and whereas the ranking remained unchanged till Could 2025, it was clearly contemplating the downgrade within the months main as much as it.
- Magnitude of personal capital: The speedy 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 financial system.
- Scores change: The rankings downgrade ws extra of a blow to satisfaction than to funds, because the default danger (and default unfold) distinction between an Aaa ranking and a Aa1 ranking is small. Austria and Finland, as an example, had Aa1 rankings in Could 2025, and their ten-year bonds, denominated in Euros, traded at a diffusion 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 speedy financial and monetary penalties of a downgrade from Aaa to Aa1 will probably be small, there are implications for analysts all over the world. Specifically, analysts must take steps when working with US {dollars} that they might already be taking already when working with most different currencies in estimating fundamental inputs into monetary evaluation.
Let’s begin with the riskfree charge, a fundamental constructing block for estimating prices of fairness and capital, that are inputs into intrinsic valuation. In precept, the riskfree charge 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 earnings securities (default spreads), are added to the riskfree charge. It’s customary apply in lots of textbooks and school rooms to make use of the federal government bond charge as the chance free charge, however that’s constructed on the presumption that governments can’t default (no less than 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 at first of 2025, in Australian, Singapore and Canadian {dollars}, the Euro (Germany). Swiss francs and Danish krone. As we famous within the first part, the belief that governments do not default is violated in apply, since some international locations select to default on native foreign money bonds, somewhat than resist inflation. If that’s the case, the federal government bond charge is not really a riskfree charge, and attending to a riskfree charge would require netting out a default unfold from the federal government bond charge:
Danger free charge = Authorities Bond charge − Default unfold for the federal government
The default unfold may 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, at first of 2025:
Thus, to get a riskfree charge in Indian rupees, Brazilian reals or Turkish lira, we begin with authorities bonds in these currencies and web out the default spreads for the international locations 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 charge after which utilizing a bigger fairness danger premium to permit for a similar nation danger.
Now that the US is not Aaa rated, now we have to comply with an identical course of to get a riskfree charge in US {dollars}:
- US 10-year treasury bond charge on Could 30, 2025 = 4.41%
- Default unfold primarily based on Aa1 ranking on Could 30, 2025 = 0.40%
- Riskfree charge in US {dollars} on Could 30, 2025 = US 10-year treasury charge – Aa1 default unfold = 4.41% – 0.40% = 4.01%
This adjustment yields a riskfree charge 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 Could 16, when the extra sensible 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 take advantage of 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 no less than 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, international locations like Canada, Germany, Australia and Singapore had been all assigned the identical premium as that attributed to the S&P 500. For international locations with rankings under Aaa, I added an “additional nation danger premium” computed primarily based upon the default spreads that went with the nation rankings:
With the rankings downgrade, I must modify this course of in 3 ways. The primary is that when computing the fairness danger premium for the S& P 500, I must web out the adjusted riskfree charge in US {dollars} somewhat than the US treasury charge, yielding a better fairness danger premium for the US. Second, for Aaa rated international locations, 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 international locations, the country danger premium will probably be computed primarily based upon the the their default spreads and the fairness danger premium estimated for Aaa rated international locations (somewhat than the US fairness danger premium):
How will the price of fairness for a agency with all of its revenues in the USA 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 Could 30, 2025, with and with out the downgrade factored in:
As you’ll be able to see, the anticipated return on the S&P 500 as of Could 30, 2025, reflecting the index stage then and the anticipated money flows, is 8.64%. Incorporating the consequences of the downgrade modifications the composition of that anticipated return, leading to a decrease riskfree charge (4.01% as a substitute of 4.41%) and a better fairness danger premium (4.63% as a substitute 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 strategy (of utilizing the ten-year US treasury bond charge because the riskfree charge and utilizing that charge 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 fabricated from it through the weekend that adopted. The monetary and financial penalties, no less than thus far, 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 affect on prices of fairness and capital for US firms, and whereas that will change, the modifications will come from macroeconomic information or from crises. For probably the most half, analysts ought to be capable of proceed to work with the US treasury charge as a riskfree charge and forward-looking fairness danger premiums, as they did earlier than the downgrade. With all of that mentioned, 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 will have introduced blowback for different international locations, particularly in rising markets, is coming to an finish. That’s wholesome, in the long run, for each the USA and the remainder of the world, however it should include brief time period ache.
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