I used to be on a household trip in August 2011 after I acquired an e-mail from a journalist asking me what I assumed concerning the S&P scores downgrade for the US. Since I keep blissfully unaware of most information tales and issues associated to markets when I’m on the seashore, I needed to search for what he was speaking about, and it was S&P’s determination to downgrade the USA, 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 price range deficits, in addition to the willingness of its political establishments to flirt with the opportunity 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 scores businesses, 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 (unfavorable) to Aa1 (steady). For the reason that scores 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. Moderately than rehash the arguments about US debt and political dysfunction, which I’m certain that you simply had learn elsewhere, I assumed I’d take this second to speak about sovereign default danger, how scores businesses fee sovereigns, the biases and errors in sovereign scores and their predictive energy, and use that dialogue as a launching pad to speak about how the US scores 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 forex and far in a overseas forex. A big proportion of sovereign defaults have occurred with overseas forex sovereign borrowing, because the borrowing nation finds itself in need of the overseas forex to satisfy its obligations. Nonetheless, these defaults, and particularly so lately, have been supplemented by international locations which have chosen to default on native forex 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 forex debt, with the ability to print cash in that forex to repay debt, however selected not to take action, as a result of they feared the implications of the inflation that might comply with greater than the implications of default.
Whereas the variety of sovereign defaults has ebbed and flowed over time, there are two factors price making concerning the knowledge. The primary is that, over time, sovereign defaults, particularly on overseas forex 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 forex defaults are persistent over time, and whereas much less frequent than overseas forex defaults, stay a big proportion of complete defaults.
The results 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 unfavorable impression on the economic system, with actual GDP dropping between 0.5% and a couple 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 research of credit score scores in 1995 discovered that the scores for international locations that had defaulted a minimum of as soon as since 1970 have been one to 2 notches decrease than in any other case related international locations that had not defaulted. In the identical vein, defaulting international locations have borrowing prices which might be about 0.5 to 1% larger 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 research 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 business stage knowledge finds that export-oriented industries are significantly damage by sovereign default.
- Sovereign default could make banking methods extra fragile. A research of 149 international locations between 1975 and 2000 signifies that the likelihood 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 research of devaluations between 1971 and 2003 finds a forty five% enhance within the likelihood of change within the high chief (prime minister or president) within the nation and a 64% enhance within the likelihood of change within the finance government (minister of finance or head of central financial institution).
In abstract, default is expensive, and international locations don’t (and shouldn’t) take the opportunity of default flippantly. Default is especially costly when it results in banking crises and forex devaluations; the previous has a longstanding impression on the capability of companies to fund their investments whereas the latter create political and institutional instability that lasts for lengthy intervals.
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 scores businesses got here in with the most important 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 aware of the scores 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 may be very dangerous.
Moody’s, Commonplace 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 Twenties, when that market was an lively one. By 1929, Moody’s supplied scores for nearly fifty central governments. With the Nice Melancholy and the Second World Conflict, investments in authorities bonds abated and with it, the curiosity in authorities bond scores. Within the Seventies, the enterprise picked up once more slowly. As not too long ago because the early Eighties, solely about 13 governments, largely in developed and mature markets, had scores, 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 listing, with a lot of them having speculative or decrease scores and by 2024, Moody’s alone was ranking 143 international locations, overlaying 75% of all rising market international locations and virtually each developed market.
Not solely have scores businesses grow to be extra lively in including international locations to their scores listing, however they’ve additionally expanded their protection of nations with extra default danger/ decrease scores. In actual fact, 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 twenty years, a minimum of 5 sovereigns, together with Japan, the UK, France and now the US, have misplaced their Aaa scores. Along with extra international locations being rated, the scores themselves have grow to be richer. Moody’s and S&P now present two scores for every nation – an area forex ranking (for home forex debt/ bonds) and a overseas forex ranking (for presidency borrowings in a overseas forex).
In assessing these sovereign scores, scores businesses draw on a large number of information, quantitative and qualitative. Moody’s describes its sovereign scores course of within the image under:
The method is broad sufficient to cowl each political and financial elements, whereas preserving wiggle room for the scores businesses to make subjective judgments on default that may result in totally different scores for 2 international locations with related financial and political profiles. The warmth map under supplies the sovereign scores, from Moody’s, for all rated international locations the beginning of 2025:
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| Moody’s sovereign scores |
Word that the greyed out international locations are unrated, with Russia being essentially the most important instance; the scores businesses 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 scores 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 listing of Aaa-rated international locations has grow to be shorter, and as Canada and Germany wrestle with price range imbalances, the chances are high that extra international locations will drop off the listing.
Sovereign Scores: Efficiency and Options
If sovereign scores are designed to measure publicity to default danger, how nicely do they do? The reply is dependent upon the way you consider their efficiency. The scores businesses present tables that listing defaults by ranking that again the proposition that sovereign scores and default are extremely correlated. A Moody’s replace of default charges by sovereign scores lessons, between 1983 and 2024, yielded the next:
Default charges rise as sovereign scores decline, with a default fee 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 elements of sovereign scores 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 scores. Whereas the battle of curiosity of getting issuers pay for the ranking is obtainable because the rationale for the upward bias in company scores, that argument doesn’t maintain up with regards to sovereign scores, since not solely are the revenues small, relative to repute loss, however a proportion of sovereigns are rated for no charges.
- There’s herd habits: When one scores company lowers or raises a sovereign ranking, different scores businesses appear to comply with swimsuit. This herd habits reduces the worth of getting three separate scores 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 scores businesses take too lengthy to vary scores, 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 scores businesses typically overreact and decrease scores 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 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 scores businesses 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 scores are good measures of nation default danger, modifications in scores typically lag modifications on the bottom, making them much less helpful to lenders and traders.
If the important thing limitation of sovereign scores 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 purchase insurance coverage in opposition to nation default danger by paying an (annualized) value. Whereas that market nonetheless has points when it comes to counterparty danger and authorized questions on what contains default, it has expanded within the final twenty years, and firstly of 2025, there have been about 80 international locations with sovereign CDS accessible on them. The warmth map under supplies an image of sovereign (10-year) CDS spreads on January 1, 2025:
As you’ll be able to see, even firstly 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 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 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 scores, 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 got 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 because of the downgrade.
The Lead-in
As I famous firstly of this put up, Moody’s was the final of the massive three sovereign scores businesses giving the USA a Aaa ranking, with S&P (in 2011) and Fitch (in 2023) having already downgraded the US. In actual fact, the 2 causes that each scores 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 scores businesses use to evaluate a rustic’s monetary standing is its debt to GDP ratio, and it’s plain that this statistic has trended upwards for the USA:
The ramping up of US debt since 2008 is mirrored in complete federal debt rising from 80% of GDP in 2008 to greater than 120% in 2024. Whereas a few of the surge in debt could be attributed to the exigencies brought on by 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 this moment is disingenuous.
The issue with the debt-to-GDP measure of sovereign fiscal standing is that it’s an imperfect indicator, as could be seen on this listing 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 can be labeled as secure and a few have Aaa scores, whereas only a few of the international locations on the bottom debt to GDP listing would qualify as secure. 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 slightly than a yr or two or perhaps a decade in the past, and the reply to that lies, I believe, 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 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 scores 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 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 scores downgrade was after shut of buying and selling on Friday, Could 16, and there was concern about how it could play out in markets, once they opened on Monday, Could 19. US equities have been truly 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 unhealthy information, and charges must 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. In actual fact, by the Could 29, 2025, virtually all the downgrade impact had light, with charges near the place they have been firstly of the yr.
You might be stunned that markets didn’t react extra negatively to the scores 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 scores modifications, with constructive (unfavorable) indicating the opportunity of a scores improve (downgrade). Moody’s modified its outlook for the US to unfavorable 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 rapid impact of a sovereign scores 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 scores downgrade ws extra of a blow to delight 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, as an example, had Aa1 scores in Could 2025, and their ten-year bonds, denominated in Euros, traded at a variety 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 will likely be small, there are implications for analysts all over the world. Specifically, analysts should take steps when working with US {dollars} that they might 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 forex, and any danger premiums, both for investing in fairness (fairness danger premium) or in mounted revenue securities (default spreads), are added to the riskfree fee. It’s customary 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 forex). 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 firstly 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 international locations select to default on native forex bonds, slightly than resist inflation. If that’s the case, the federal government bond fee is not actually 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 could 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 forex authorities bonds had default danger, firstly 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 international locations in query. We do that to make sure that we do not double rely 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 got to comply with an analogous course of to get a riskfree fee in US {dollars}:
- US 10-year treasury bond fee on Could 30, 2025 = 4.41%
- Default unfold based mostly on Aa1 ranking on Could 30, 2025 = 0.40%
- Riskfree fee in US {dollars} on Could 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 is usually 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 specific.
The scores downgrade for the US may even 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 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, international locations like Canada, Germany, Australia and Singapore have been all assigned the identical premium as that attributed to the S&P 500. For international locations with scores under Aaa, I added an “further nation danger premium” computed based mostly upon the default spreads that went with the nation scores:
With the scores 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} slightly than the US treasury fee, 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 should 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 likely be computed based mostly upon the the their default spreads and the fairness danger premium estimated for Aaa rated international locations (slightly 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 fee (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 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 scores downgrade of the US made the information, and far was manufactured from it in the course of 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 that will change, the modifications will come from macroeconomic information or from crises. For essentially 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 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 might 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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