Aer the downgrade, yields on US government securities
fell across the term spectrum as investors around the world
ed to the safe haven of US bonds. US stocks experienced
negative returns in the following weeks but logged positive
performance from the day of the downgrade to month end.
ese events raise questions about whether changes in
sovereign debt ratings impact the nancial markets. e short
answer is that results are mixed, and that many other factors
aect a country’s cost of capital and stock market returns.
Regarding bond markets, history oers examples of major
developed countries that experienced a credit downgrade
without a signicant rise in interest rates.
Examples include
Australia, Canada, and Japan, which lost their top ratings in
1986, 1992, and 1998, respectively.
Other research suggests that countries with high credit
ratings may withstand a downgrade better than countries
with lower ratings. One study looked at sovereign credit
rating downgrades since 1990 and found that bond yields
In early August, Standard & Poor’s downgraded US government
debt from a top-rated AAA to AA+.
In the weeks preceding the
event, some market observers expected a downgrade to result
in higher interest rates and lower stock returns.
Sovereign Debt Ratings
and Stock Returns
September 2011
1. A sovereign credit rating is an assessment of a government’s ability to pay its debts. The US had held S&P’s top rating since 1941. S&P made the
announcement after business hours on Friday, August 5, but word of the downgrade leaked during the day. Although timing of the announcement
was a surprise, the downgrade was mostly expected, as S&P had issued a negative long-term outlook for the US in April and July. The other top
credit agencies, Moody’s Investors Service and Fitch Ratings, have maintained top ratings for the US.
2. Two weeks following the downgrade, the US market, as measured by the Russell 3000 Index, logged a negative 6.82% return (August 5– 19).
However, from the day of the announcement to month end, the market returned a positive 1.6%. Russell data copyright © Russell Investment
Group 1995–2011, all rights reserved.
3. Tom Lauricella, “Lessons of Lower Ratings,” Wall Street Journal, July 30, 2011.
changed little among countries downgraded from the
highest triple-A rating. However, countries with lower
credit ratings (single A or below) experienced significant
interest rate increases following their downgrade.
Another question is whether the US downgrade has played
a role in the US market downturn—and research does not
provide convincing evidence.
Figure 1 summarizes stock market performance of
respective countries before and after a ratings change. It is
based upon a study of ratings changes made by Moodys
from 1983 to 2009. During the twenty-seven-year period,
the ratings agency made seventy-one upgrades and twenty-
five downgrades to governments in the developed and
emerging markets tracked by MSCI.
The study identified the date of each change and logged
each countrys market performance in the twelve months
before and twelve months after the event. Each countrys
market returns were compared to the respective market
index and the excess return averaged for all events. (Excess
return refers to performance above or below the respective
market index, either MSCI EAFE or MSCI Emerging
Markets, as appropriate.)
The aggregate results show that stock markets of upgraded
countries outperformed their respective market index
in the twelve months before the rating change (13.83%),
while stocks in downgraded countries aggregately
underperformed the market index before the event.
However, cumulative returns in the twelve months
following a ratings change were almost the same for the
upgraded and downgraded countries (3.87% vs. 3.73%).
ese results suggest that market prices reect all available
information and expectations about a country’s economic
prospects—including the possibility of a ratings change. By
the time a country’s debt rating is upgraded or downgraded,
the market has already integrated the news into prices.
Stock markets reected positive economic developments
prior to a ratings upgrade and negative developments
before a ratings downgrade. Aer the event, markets did not
appear to perform much dierently, in aggregate.
is research underscores the importance of looking
to market prices for signals about the scal health and
prospects of a country or a company. Based on the foregoing
analysis, markets appear to work faster and more accurately
than ratings rms to assess a country’s nancial condition
and evaluate the potential impact on its cost of capital and
equity market.
Analysis conducted by Dimensional Fund Advisors using sovereign
bond rating data from Moody’s Investors Services, “Sovereign Default
and Recovery Rates, 1983–2009.” Returns are in US dollars and
represent performance in excess of MSCI EAFE Index for developed
markets and MSCI Emerging Markets Index for emerging markets. A
positive excess return indicates market outperformance; a negative
excess return indicates underperformance. The table reports the return
of an equal-weighted, event-time portfolio. Past performance is no
guarantee of future results.
13.83% 3.87%
−6.56% 3.73%
4. Ivan Rudolph-Shabinsky and Dennis Shen, “When ‘Risk-Free’ Isn’t Risk Free: The Impact of a US Treasury Downgrade” (white paper, Alliance
Bernstein, June 2011), www.alliancebernstein.com/CmsObjectABD/PDF/Research_WhitePaper/Treasury-Downgrade_110706.pdf.
5. The twelve-month aggregate excess performance prior to the ratings change was statistically significant, while the twelve-month returns after the
ratings change were not.
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All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This information is for
educational purposes only and should not be considered investment advice or an offer of any security for sale.
OpenCircle Wealth Partners is an investment advisor registered with the State of Connecticut.