Equity and Debt Market Responses to Sovereign Credit Ratings Announcements

Abstract

We study the impact of changes in sovereign ratings and outlooks on international capital markets using a comprehensive database of 34 countries, covering the major regions in the world over the period 1990-2000. We find the rating agencies provide financial markets with new tradable information. Specifically, they affect not only the instrument being rated (bonds) but also stocks. Interestingly, bond markets react differently than stock markets in many respects. We find, only for bond market returns, a positive impact is significant when the economic outlook is upgraded and outlook changes appear to be at least as important as rating changes. In addition, downgraded ratings and economic outlooks occur mainly during bond market downturns, raising a possibility that rating agencies may exacerbate a bond bear market. Only downgrade has a discernible impact on equity and bond returns and the effects of rating announcement are significantly asymmetric. On equity returns, the market responses of downgrade are more pronounced in the cases of high inflation, low fiscal balance, and local currency debt; in contrast, the market responses of downgrade across class are more pronounced in the cases of low current account and foreign currency debt. On bond returns, the market responses of downgrade are more pronounced in the cases of a relatively ailing economy as proxied by emerging market, high inflation, and low current account; on the other hand, the market responses of downgrade across class are more pronounced in the cases of a relatively healthy economy as proxied by low inflation, high liquidity, and during non-crisis period. This study has important implications for investors' international asset allocation and for regulatory agents such as the Basel Committee increasingly depending on credit rating agencies such as Moody's and S&P's in their regulatory deliberations.

Keywords: Sovereign credit rating, Bond market reaction, Stock market reaction

JEL Classification: G14, G15, H63