The case for ‘truly-long-term’ debt ratings
As challenges of climate change and ageing mount, investors need benchmarks for risks in decades to come.
Dr. Moritz Kraemer
Jul 13, 2021
Our century is characterised by the two separate megatrends of ageing populations and climate change. Both are without example in recent history. And both will take decades to fully unfold.
The need to gauge the impact on credit risk is becoming more pressing. It is nowhere more urgent than in the asset class that is the ultimate backstop for all challenges and calamities that may befall us: government bonds.
The pandemic made abundantly clear that the buck always stops with governments. When the social and economic fabric is under strain, the state will be called to the rescue. Public finances and sovereign ratings will feel the pain.
Investors searching for long-term indicators of sovereign credit risk find a deep void. There aren’t any. Credit agencies have coyly tiptoed into appraising the possible impact of climate change and ever larger cohorts of seniors, but it seems they pulled back. Maybe they were too concerned about what they saw.
S&P warned in 2016 that unless governments take decisive action, burgeoning old age-related spending would erode public finances to such an extent that the G7 sovereign debt would have to be downgraded to the brink of junk status before 2050. In 2018 Moody’s arrived at similar conclusions: debt affordability will be at risk.
As for climate change, simulations by economists at Cambridge university based on S&P’s sovereign methodology suggest that unabated global warming will lead to significant cuts in ratings. The average downgrade of G7 sovereigns plus China would be over 3.5 notches by the end of the century. Canada, China and the US would be worst affected.
Those are near-worst-case scenarios. Yet even under a more robust policy reaction to climate change, the trend of sovereign ratings drifting downward will persist.
For example, the unweighted average S&P rating of the G7 countries dropped by an average of 2 notches since 2000. These pre-pandemic downgrades occurred even without the added stresses of climate change and ageing. Add those to the mix and it is easy to see how the drop in sovereign ratings will continue, if not accelerate.
Right now, there is no measure that would describe this downgrade risk. The agencies’ “long-term” ratings supposedly reflect credit risk up to 10 years. That time horizon is designed to assess fundamental risks through an economic cycle. But the changes to our climate and demographics are not cyclical. They are structural. And they are long term. In fact, the agencies’ time horizon may be fictitious, anyway: in real life, their economic and financial forecasts rarely extend beyond three years.
But whether the time horizon is 10 years or three, it is too short to incorporate longer term credit constraints. It is simply not credible to assign a default probability to a five-year bond identical to that of a 50-year bond. The risks are plainly more elevated for longer-term debt.
The time has come to make long-term ratings truly long term. One solution would be a regulatory requirement for agencies to issue “truly-long-term” sovereign ratings, distinct from their current so-called long-term ratings. Failing to do so would bar them from rating government bonds above a certain initial maturity, eg 10 years.
This differentiation in rating time horizon would mirror the IMF’s approach to debt sustainability analysis. It runs one assessment for the medium term (up to five years) and a long-term projection (up to 20 years).
It is likely that the agencies are fully aware of their myopic method. So why have they not proactively extended the time horizon? Inertia is certainly one factor. But change is also not in the agencies’ (or sovereign governments’) interest.
Change would require significant investment into new analytical skills without a plausible prospect that issuers will recompense the agencies for the added effort. Even less so, as the message embodied in a truly-long-term rating is unlikely to be a happy one. There is no discernible commercial upside.
The Financial Stability Board should therefore provide the required leadership. Through its previous work on climate-related financial disclosure, the FSB has the competency and the credibility to shift the debate. Changes like the introduction of truly-long-term ratings could take years until full implementation. In the meantime, the unaccounted for credit risks will mount inexorably.
We now have an urgent short-term need for long-term ratings. The risks can be calculated. Investors, policymakers and citizens have a right to know.
This blog was first published as a Market Insight opinion article on July 8, 2021 in the Financial Times.