I used to be on a household trip in August 2011 once I obtained an electronic mail from a journalist asking me what I assumed in regards to 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 america, which had at all times loved AAA, the best sovereign score that may be granted to a rustic, to AA+, reflecting their issues about each the fiscal challenges confronted by the nation, with mounting commerce and finances 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 companies, 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 (secure). Because the 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. Slightly than rehash the arguments about US debt and political dysfunction, which I’m positive that you simply had learn elsewhere, I assumed I’d take this second to speak about sovereign default danger, how scores companies charge 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 around the globe.
Sovereign Defaults: A Historical past
By way of time, governments have typically been depending on debt to finance themselves, some within the native foreign money and far in a overseas foreign money. A big proportion of sovereign defaults have occurred with overseas foreign money sovereign borrowing, because the borrowing nation finds itself wanting the overseas foreign money to satisfy its obligations. Nonetheless, these defaults, and particularly so in recent times, have been supplemented by nations which have chosen to default on native foreign money borrowings. I take advantage of the phrase “chosen” as a result of most nations have the capability to keep away from default on native foreign money debt, having the ability to print cash in that foreign money to repay debt, however selected not to take action, as a result of they feared the results of the inflation that will comply with greater than the results of default.
Whereas the variety of sovereign defaults has ebbed and flowed over time, there are two factors value making in regards to the knowledge. The primary is that, over time, sovereign defaults, particularly on overseas foreign money 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 foreign money defaults are persistent over time, and whereas much less frequent than overseas foreign money defaults, stay a major proportion of whole defaults.
The results of sovereign default have been each financial and political. Apart from the apparent implication that lenders to that authorities lose some or quite a lot of what’s owed to them, there are different penalties. Researchers who’ve examined the aftermath of default have come to the next conclusions in regards to the short-term and long-term results of defaulting on debt:
- Default has a unfavorable affect on the financial system, with actual GDP dropping between 0.5% and a pair of%, however the bulk of the decline is within the first 12 months after the default and appears to be quick lived.
- Default does have an effect on a rustic’s long-term sovereign score and borrowing prices. One research of credit score scores in 1995 discovered that the scores for nations that had defaulted at the least as soon as since 1970 have been one to 2 notches decrease than in any other case comparable nations that had not defaulted. In the identical vein, defaulting nations have borrowing prices which are about 0.5 to 1% greater than nations that haven’t defaulted. Right here once more, although, the consequences of default dissipate over time.
- Sovereign default may 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 degree knowledge finds that export-oriented industries are notably harm by sovereign default.
- Sovereign default could make banking programs extra fragile. A research of 149 nations between 1975 and 2000 signifies that the likelihood of a banking disaster is 14% in nations which have defaulted, an eleven percentage-point improve over non-defaulting nations.
- Sovereign default additionally will increase the probability of political change. Whereas not one of the research concentrate on 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% improve within the likelihood of change within the high chief (prime minister or president) within the nation and a 64% improve within the likelihood of change within the finance govt (minister of finance or head of central financial institution).
In abstract, default is expensive, and nations don’t (and mustn’t) take the opportunity of default calmly. Default is especially costly when it results in banking crises and foreign money devaluations; the previous has a longstanding affect on the capability of corporations to fund their investments whereas the latter create political and institutional instability that lasts for lengthy durations.
Sovereign Scores: Measures and Course of
Since few of us have the sources or the time to dedicate to understanding small and unfamiliar nations, 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 companies got here in with the largest benefits:
- They’ve been assessing default danger in firms for 100 years or extra and presumably can switch a few of their abilities to assessing sovereign danger.
- Bond traders who’re acquainted with 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 could be very dangerous.
Moody’s, Customary and Poor’s and Fitch’s have been score company bond choices for the reason that early a part of the 20th century. Moody’s has been score company bonds since 1919 and began score authorities bonds within the Nineteen Twenties, when that market was an lively one. By 1929, Moody’s offered scores for nearly fifty central governments. With the Nice Despair 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 lately because the early Nineteen Eighties, solely about 13 governments, principally in developed and mature markets, had scores, with most of them commanding the best degree (Aaa). The last decade from 1985 to 1994 added 34 nations to the sovereign score record, with a lot of them having speculative or decrease scores and by 2024, Moody’s alone was score 143 nations, masking 75% of all rising market nations and virtually each developed market.
Not solely have scores companies change into extra lively in including nations to their scores record, however they’ve additionally expanded their protection of nations with extra default danger/ decrease scores. Actually, the variety of Aaa rated nations was the identical in 1985, when there have been 13 rated nations, as in 2025, when there have been 143 rated nations. Within the final 20 years, at the least 5 sovereigns, together with Japan, the UK, France and now the US, have misplaced their Aaa scores. Along with extra nations being rated, the scores themselves have change into richer. Moody’s and S&P now present two scores for every nation – an area foreign money score (for home foreign money debt/ bonds) and a overseas foreign money score (for presidency borrowings in a overseas foreign money).
In assessing these sovereign scores, scores companies draw on a mess of knowledge, 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 companies to make subjective judgments on default that may result in completely different scores for 2 nations with comparable financial and political profiles. The warmth map under supplies the sovereign scores, from Moody’s, for all rated nations the beginning of 2025:
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| Moody’s sovereign scores |
Be aware that the greyed out nations are unrated, with Russia being probably the most vital instance; the scores companies withdrew their score for Russia in 2022 and never reinstated it but. There have been solely a handful of Aaa rated nations, 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 adjustments, 4 upgrades and 4 downgrades, with the US downgrade from Aaa to Aa1 as the best profile change
With the US downgrade, the record of Aaa-rated nations has change into shorter, and as Canada and Germany battle with finances imbalances, the chances are high that extra nations will drop off the record.
Sovereign Scores: Efficiency and Alternate options
If sovereign scores are designed to measure publicity to default danger, how effectively do they do? The reply will depend on the way you consider their efficiency. The scores companies present tables that record defaults by score 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 charge 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 facets 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 companies 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 score 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 fame loss, however a proportion of sovereigns are rated for no charges.
- There may be herd conduct: When one scores company lowers or raises a sovereign score, different scores companies appear to comply with swimsuit. This herd conduct reduces the worth of getting three separate scores companies, since their assessments of sovereign danger are now 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 are up to date and well timed. It has lengthy been argued that scores companies take too lengthy to alter scores, and that these adjustments 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 companies 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 nations which are principally depending on overseas capital for his or her funds.
- Regional biases: There are a lot of, particularly in Asia and Latin America, that consider that the scores companies are too lax in assessing default danger for North America and Europe, overrating nations in these areas, whereas being too stringent of their assessments of default in Asia, Latin America and Africa, underrating nations in these areas.
In sum, the proof means that whereas sovereign scores are good measures of nation default danger, adjustments in scores typically lag adjustments 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 can 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 includes default, it has expanded within the final 20 years, and in the beginning of 2025, there have been about 80 nations with sovereign CDS out there 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 in the beginning of 2025, the market was drawing a distinction between the most secure Aaa-rated nations (Scandinavia, Switzerland, Australia and New Zealand), all with sovereign CDS spreads of 0.20% or under, and extra dangerous Aaa-rated nations (US, Germany, Canada). Throughout 2025, the market shocks from tariff and commerce wars have had an impact, with sovereign CDS spreads rising, 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, now we have 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 in the beginning of this put up, Moody’s was the final of the large three sovereign scores companies giving america a Aaa score, with S&P (in 2011) and Fitch (in 2023) having already downgraded the US. Actually, the 2 causes that each scores companies offered 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 companies use to evaluate a rustic’s monetary standing is its debt to GDP ratio, and it’s simple that this statistic has trended upwards for america:
The ramping up of US debt since 2008 is mirrored in whole federal debt rising from 80% of GDP in 2008 to greater than 120% in 2024. Whereas a few of the surge in debt may be attributed to the exigencies brought on by crises (the 2008 banking disaster and the 2020 COVID bailouts), the troubling reality is that the debt has outlasted the crises and blaming the crises for the debt ranges at the moment is disingenuous.
The issue with the debt-to-GDP measure of sovereign fiscal standing is that it’s an imperfect indicator, as may be seen on this record of nations that scored highest and lowest on this measure in 2023:
Most of the nations with the best debt to GDP ratios can be labeled as protected and a few have Aaa scores, whereas only a few of the nations on the bottom debt to GDP record would qualify as protected. 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 reasonably than a 12 months or two or perhaps a decade in the past, and the reply to that lies, I believe, within the political part. 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 companies), 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 is perhaps winding down, and that america, 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 might play out in markets, after they opened on Monday, Could 19. US equities have been really 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 spite of everything, an issuer downgrade for any bond is dangerous information, and charges ought to be anticipated to rise to mirror greater 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 doubtlessly may add to the deficit in future years. Actually, by the Could 29, 2025, virtually the entire downgrade impact had pale, with charges near the place they have been in the beginning of the 12 months.
It’s possible you’ll 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 surprising, 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 score, and it was solely a matter of time earlier than it joined the opposite two companies. Second, along with reporting a sovereign score, Moody’s discloses when it places a rustic on a look ahead to a scores adjustments, 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 score remained unchanged till Could 2025, it was clearly contemplating the downgrade within the months main as much as it.
- Magnitude of personal capital: The instant impact of a sovereign scores downgrade is on authorities borrowing, and whereas the US does borrow huge quantities, non-public capital (within the type of fairness and debt) is a far greater supply of financing and funding for the financial 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 score and a Aa1 score is small. Austria and Finland, as an illustration, had Aa1 scores in Could 2025, and their ten-year bonds, denominated in Euros, traded at an expansion of about 0.15- 0.20% over the German ten-year Euro bond; Germany had a Aaa score.
Penalties for valuation and funding evaluation
Whereas the instant financial and monetary penalties of a downgrade from Aaa to Aa1 will probably be small, there are implications for analysts around the globe. Specifically, analysts should take steps when working with US {dollars} that they could already be taking already when working with most different currencies in estimating primary inputs into monetary evaluation.
Let’s begin with the riskfree charge, a primary constructing block for estimating prices of fairness and capital, that are inputs into intrinsic valuation. In precept, the riskfree charge is what you’ll earn on a assured funding in a foreign money, and any danger premiums, both for investing in fairness (fairness danger premium) or in mounted revenue securities (default spreads), are added to the riskfree charge. It’s normal apply in lots of textbooks and school rooms to make use of the federal government bond charge as the chance free charge, however that’s constructed on the presumption that governments can not default (at the least on bonds issued within the native foreign money). Utilizing a Aaa (AAA) score as a (lazy) proxy for default-free, that’s the rationale we used to justify authorities bond charges as riskfree charges in the beginning of 2025, in Australian, Singapore and Canadian {dollars}, the Euro (Germany). Swiss francs and Danish krone. As we famous within the first part, the belief that governments do not default is violated in apply, since some nations select to default on native foreign money bonds, reasonably than resist inflation. If that’s the case, the federal government bond charge is now not really a riskfree charge, and attending to a riskfree charge would require netting out a default unfold from the federal government bond charge:
Danger free charge = Authorities Bond charge − Default unfold for the federal government
The default unfold may be estimated both from the sovereign bond score (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 foreign money authorities bonds had default danger, in the beginning of 2025:
Thus, to get a riskfree charge in Indian rupees, Brazilian reals or Turkish lira, we begin with authorities bonds in these currencies and internet out the default spreads for the nations 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 charge after which utilizing a bigger fairness danger premium to permit for a similar nation danger.
Now that the US is now not Aaa rated, now we have to comply with an identical course of to get a riskfree charge in US {dollars}:
- US 10-year treasury bond charge on Could 30, 2025 = 4.41%
- Default unfold primarily based on Aa1 score on Could 30, 2025 = 0.40%
- Riskfree charge in US {dollars} on Could 30, 2025 = US 10-year treasury charge – Aa1 default unfold = 4.41% – 0.40% = 4.01%
This adjustment yields a riskfree charge of 4.01% in US {dollars}, and additionally it is constructed on the presumption that the default unfold manifested after the Moody’s downgrade on Could 16, when the extra reasonable studying is that US treasury markets have been carrying a default unfold embedded in them for years, and that we don’t make it specific.
The scores downgrade for the US may also 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 at the least till the beginning of this 12 months, I used that as a premium for all mature markets (with a AAA (Aaa) score because the indicator of maturity). Thus, nations like Canada, Germany, Australia and Singapore have been all assigned the identical premium as that attributed to the S&P 500. For nations with scores under Aaa, I added an “further nation danger premium” computed primarily based 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 charge in US {dollars} reasonably than the US treasury charge, yielding a better fairness danger premium for the US. Second, for Aaa rated nations, 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 score for the US. The third is that for all different nations, the country danger premium will probably be computed primarily based upon the the their default spreads and the fairness danger premium estimated for Aaa rated nations (reasonably than the US fairness danger premium):
How will the price of fairness for a agency with all of its revenues in america 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 degree then and the anticipated money flows, is 8.64%. Incorporating the consequences of the downgrade adjustments the composition of that anticipated return, leading to a decrease riskfree charge (4.01% as an alternative of 4.41%) and a better fairness danger premium (4.63% as an alternative of 4.23%). Thus, whereas the anticipated return for the typical 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 traditional strategy (of utilizing the ten-year US treasury bond charge because the riskfree charge and utilizing that charge 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, at the least 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 affect on prices of fairness and capital for US firms, and whereas which will change, the adjustments will come from macroeconomic information or from crises. For probably the most half, analysts ought to be capable of proceed to work with the US treasury charge as a riskfree charge 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 financial actions that will have introduced blowback for different nations, particularly in rising markets, is coming to an finish. That’s wholesome, in the long run, for each america and the remainder of the world, however it would include quick time period ache.
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