Another Representative Why Bond Investors Ignore Developed Sovereign Credit Ratings
Understanding Government Finance (paperback edition only released!), developed sovereigns with a free-floating authorities are non at peril of involuntary default; rather the peril is of voluntary repudiation of debt. Although closed to investors stimulate got been wearisome learners close this reality -- convey the parade of JGB shorts -- most authorities bond investors stimulate got accepted this reality.
Although credit ratings are unfortunately worked into bond indices, banking concern regulations process the sovereign issuer equally special, with a 0% peril weighting, Furthermore, everyone knows that the authorities cannot endure forced to default. This cognition either comes from something resembling Modern Monetary Theory's analysis of governmental finance operations, or the to a greater extent than primitive "they tin lav only impress the money."
Some international investors could endure dissuaded from investing due to a rating action, but such investors are inevitably tourists. No affair the size of their sum portfolios, their exposure to an private province is going to much smaller than domestic investors, whose portfolios are concentrated inward the local currency. (The U.K. was notoriously treacherous for relative value investors from overseas; trading was dominated yesteryear a modest gild of large local institutions, in addition to what appeared to endure mispricing to outsiders was only a reflection of seat jockeying alongside those players. Unless you lot understood what was going on, in that location was a expert postulate chances you lot would destination upward existence run over similar a steamroller.)
As a result, bond yields follow charge per unit of measurement expectations, in addition to non rating agency opinions.
Moreover, the ratings agency justification for these moves makes real picayune sense. The Brexit plebiscite had no bearing whatsoever on Britain's willingness to brand expert on its bonds. One could maybe combat close the possibility of the secession of Scotland leading to disputes over debt repayment, but that is a far-fetched possibility. The alone justification for the ratings motility was to create headlines equally a cast of inexpensive publicity for the ratings agencies.
The downgrade of the U.S.A. during the debt bound standoff was at to the lowest degree somewhat justified; afterward all, the dispute could stimulate got led direct to a default (although those inward favour of non lifting the debt bound strenuously argued that it would non atomic number 82 to default; the belief was that spending would endure cutting to save the limit). In that case, in that location at to the lowest degree was a interrogation close the willingness to pay (a betoken that Warren Mosler emphasised at the time).
Real Risk Is Inflation, Which Is Not The Rating Agency Mandate
With floating currency sovereigns, the existent peril is inflation, non default. (Some crackpots lump inflation inward with "default," which utterly destroys the important of default, which is a breach of contractual obligations.) Although rating agencies sometimes nod to inflation peril when they brand upward their sovereign ratings, they practise non encompass it. After all, if they did role that metric, Nippon would stimulate got the best credit rating on the planet, which messes upward fireside scare stories close the debt-to-GDP ratio.Where "Government" Ratings Matter
If countries are borrowing inward a unusual currency, they tin lav default similar whatever other "user of the currency." This also applies to the euro zone, equally the private nations no longer stimulate got command of the key bank. In the post-1980 era, such countries (outside Europe) tend to endure emerging markets. For such sovereigns, I stimulate got non seen prove that rating agency ratings are worse than whatever other rootage of information on default risk.Additionally, for sub-sovereigns, ratings tin lav endure useful. These are also entities that stimulate got a rail tape of defaulting, in addition to and then the rating agencies stimulate got actual default information to calibrate against. (The lack of free-floating sovereign defaults explains why the rating agencies stimulate got a hard fourth dimension with them; they run best using historical default studies. Lack of default information is also the excuse used for the ratings failures with securitisations earlier the Financial Crisis.)
If you lot aspect at Canadian provinces, spreads were somewhat related to ratings. (That partially reflected the reality that ratings followed spreads with a lag.) Nobody serious has been concerned close defaults (although secession has periodically been an issue), but a rating cutting would endure a technical element that leads you lot to await a wider spread.
At the minimum, retail investors likely prefer higher-rated bonds, in addition to they affair inward the illiquid provincial bond market. This illiquidity agency that the bonds tin lav merchandise at a reasonable spread (100 footing points, say) fifty-fifty when the expected default peril is nil.
However, the rating is non the most of import technical factor. Some provinces are quite small, in addition to their bonds outstanding are negligible inward size. The premium for illiquidity for these bonds tin lav endure much to a greater extent than important than the trial of their credit rating. (Illiquidity explains why Canada Mortgage Bonds (CMB's) tin lav merchandise at a decent spread over Government of Canada bonds, fifty-fifty though CMB's are a sum faith in addition to credit obligation of the same issuer.)
(c) Brian Romanchuk 2016
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