When a country borrows money, lenders want to know how likely they are to be paid back. Sovereign credit ratings are an attempt to answer that question with a simple grade, and when those grades change, or even look likely to change, the effects can ripple through bond markets and currencies.
What a sovereign rating is
A sovereign credit rating is an assessment of a government’s ability and willingness to repay its debts in full and on time. The best-known ratings come from three agencies: S&P Global, Moody’s and Fitch.
Each uses a letter scale. At the top sits AAA, or Aaa in Moody’s terms, which signals the lowest assessed risk. Below that come AA, A and BBB, each with finer steps. Anything from BBB- upwards, or Baa3 for Moody’s, is known as investment grade. Below that line, debt is considered speculative, sometimes called high yield or, less politely, junk.
What agencies look at
Rating agencies consider a wide range of factors. These include the size of a country’s debt compared with its economy, how fast that debt is growing, the strength and stability of its growth, the credibility of its institutions, and its political ability to make difficult decisions on spending and tax.
Budget deficits matter a great deal. A government that consistently spends far more than it raises will see its debt climb, and if there is no clear plan to stabilise it, agencies may grow more cautious.
Agencies also publish an outlook alongside the rating: positive, stable or negative. A negative outlook signals that a downgrade is possible over the next year or two.
Why ratings matter to markets
Ratings influence who can hold a country’s bonds. Some funds are only allowed to own investment-grade debt, and many have rules linked to rating levels. A downgrade can therefore force some investors to sell or reduce holdings.
More broadly, a downgrade can raise a country’s borrowing costs, as investors demand a higher yield to compensate for perceived risk. That higher yield feeds into government finances, which can make the debt problem harder to solve.
If you are new to government bonds, our guide to what gilts are explains how bonds and yields work, using the UK as an example.
The link to currencies
Concerns about a country’s public finances can weigh on its currency, particularly if investors fear political gridlock or rising borrowing costs. The current backdrop in Europe is a case in point. Worries about France’s debt and deficit have weighed on the euro, which recently slipped to a 17-month low against the dollar. Our explainer on how French fiscal stress hits the euro covers that story in more detail.
It is worth noting that the market often moves before the agencies do. Bond yields and currencies tend to react to the underlying worries first, and a formal downgrade sometimes arrives after much of the adjustment has already happened.
Ratings are opinions, not certainties
Credit ratings are informed judgements, but they are judgements all the same. Agencies have been criticised in the past for reacting too slowly or too sharply, and different agencies can disagree about the same country. Markets also have their own view, which shows up in the gap between one country’s bond yields and another’s.
For that reason, traders tend to treat ratings as one input rather than the final word. Scheduled rating reviews, which agencies announce in advance for many European countries, can become events in their own right, often published after markets close on a Friday.
What beginners can take from it
Understanding ratings helps make sense of headlines about government debt and why they can move markets. If you trade currencies or bond-sensitive assets, it is worth knowing when a review is due for the countries you follow, and allowing for the possibility of a sharp move when markets reopen.
If you would like to build a better understanding of the macro forces behind market moves, our free trader assessment can help you see where your knowledge is strong and where to focus next.
