A little more than a year ago, on January 30, 2020, the World Health Organization declared COVID-19 to be a “Public Health Emergency of International Concern”. By March 11, the WHO had designated COVID-19 as a pandemic—one that would go on to precipitate the most severe peacetime recession since the Great Depression.

The OECD estimates that the global economy shrank by 3.4% in 2020. This was by far the most significant contraction in living memory; even 2009, the nadir of the global financial crisis, saw the world’s economy shrink by just 0.1%. According to the IMF’s estimates the slump was twice as large in so-called advanced economies (AE, -4.9%) than it was in emerging markets and developing economies (EMDE, -2.4%, all country group definitions follow the IMF classification).

AEs will only collectively regain their pre-pandemic level of economic activity towards the middle of 2022. Some economies, such as the euro area, will not break even before the end of that year, with several countries (including France, Italy, and Spain) taking even longer than that. Meanwhile, among EMDE countries, heavyweights such as Mexico and South Africa will have to wait until at least 2023 for their economies to rebound to where they were in 2019. Most EMDEs are expected to catch up faster than the typical AE. Once you factor in the uncertainty around those forecasts and some potential downside risk, several countries—both rich and poor—could end up seeing at least half a decade of lost economic growth; a toll exceeded only by the loss of human well-being and lives.

S&P Global calculated that net commercial borrowing by sovereigns reached USD 10 trillion globally in 2020 (including the change in short-term debt). While that number is expected to gradually drift back down, this year’s sovereign net long-term issuance will remain 2.5 times higher than pre-COVID levels. In 2020, government debt ratios in advanced economies surged by 20 percentage points to 124% of GDP, a level the IMF estimates will remain unchanged until at least 2025. In EMDEs, debt ratios remain at less lofty levels, collectively rising “only” nine percentage points to 61% of GDP last year—the first time that the debt ratio for this group has broken the 60% threshold. The IMF also predicts that EMDE public debt will rise even further, hitting almost 70% by 2025.

All things considered, then, COVID-19 has posed an unprecedented negative shock to governments’ creditworthiness. Notwithstanding the human calamity and economic turmoil caused by the coronavirus, the crisis has afforded us a rare glimpse into how sovereign rating agencies behave when a sudden and unexpected storm hits every country at once. To get a handle on this, we examined the rating behaviours of the three dominant rating agencies: Moody’s, S&P and Fitch (the “Big-Three”). In assessing the “ratings reaction function”, we analysed all rating actions during the period in which the brunt of the impact was felt: from January 31, 2020 to February 28, 2021.

Poorer countries more exposed to downgrade

When we compare the sovereign ratings by the Big-Three at the end of that period with the starting rating, we find that 48 sovereigns had seen their rating cut by at least one agency. Half of those sovereigns experienced more than one downgrade. Fitch was the most active, with 45 downgrade episodes (or 26% of the sovereigns it rates), followed by S&P (37, or 18%) and Moody’s (33, or 20%).

Chart 1 shows the rating downgrades in cumulative notches (since there have been several multiple notch downgrade episodes, the numbers differ from the number of downgrade episodes referred to in the previous paragraph). The first observation we can make, with even a cursory analysis, is that the agencies seem to have largely spared AEs from downgrades.

Although, as shown above, the economic fallout from the virus was more severe in AEs they experienced only six notches of cumulative downgrades (or 4.6% of all downgrades). This is a stark contrast to the 29% share of AEs in the totality of all Big Three issuer ratings. Except for the U.K.-downgrade by Moody’s, all other AE-downgrades were by Fitch (Canada, Italy, U.K., Slovakia, and Hong Kong). That is all. Meanwhile, S&P has not lowered any AE sovereign rating since 2017 and, alone among rating agencies, did not do so in 2020. In fact, the agency evenimprovedits rating outlook for Italy, one of the countries hit hardest by the pandemic, from negative to stable in September 2020. The agency’s only positive outlook going into 2021 was for New Zealand (also an AE), which was eventually upgraded in February 2021. Looking ahead, S&P assigned just three (Australia, Slovakia, and Spain) of its 27 negative outlooks to AEs. Therefore, we should expect the relatively strong ratings resilience of AEs to remain in place during 2021.

EMDEs did not fare so well. Chart 2 displays the share of each agency’s portfolio of rated sovereigns that was downgraded by at least one notch. Sovereigns in Sub-Saharan Africa (41%) and Latin America and the Caribbean (35%) were most likely to be downgraded.

Non-AE Central and Eastern Europe (CEE) includes several economies, especially some EU members, that are close to being considered AEs. Like AEs, that region, too, was almost entirely spared: Moody’s lowered Turkey’s rating and Fitch downgraded Armenia. S&P took no action in the region. Fitch was the most severe agency in almost all regions. S&P was the ratings firm offering most forbearance, except in Sub-Saharan Africa, where it was the downgrade leader, lowering the ratings of 50% of sovereigns in the region.

What explains these inter-regional differences? One could argue that rich, diversified countries are more resilient to shocks than poorer, more vulnerable economies. That is undoubtedly true. However, it is also true that the shock delivered by COVID-19 was not evenly distributed across economies. In fact, the hit to growth and public debt accumulation has been twice as large for AEs than for EMDEs, not to mention their significantly larger death tolls. Given that context, it is not at all clear why rich countries’ ratings remained largely untouched even as their poorer peers were subject to more extensive downgrades. More analysis is required to solve this puzzle.

With the quality of a rating signal being significantly dependent on its timeliness, the overwhelming speed at which the virus spread across the globe last spring made it critical for agencies to reassess their ratings just as quickly.

Chart 3 reveals a flurry of downgrade activity during March and April 2020, especially by Fitch and S&P.

After that, the pace became somewhat more leisurely, which may have been partly due to the gradual (albeit, ultimately, temporary) retreat in the number of COVID cases. As the northern summer ended, downgrade activity picked up once more, especially by Moody’s. However, when the second wave began in Q4 and forced governments to declare renewed lockdowns and stimulus spending, downgrade actions did not surge in tandem. In January 2021, when much of the world was in the grip of the second wave, not a single rating was lowered.

For the time being the agencies were largely done, possibly due to hopes for a quick recovery following a successful vaccination drive. That said, the continuance of negative outlooks, especially on the ratings of EMDE sovereigns, suggests that ratings agencies see a relevant risk of further ratings erosion.

Fitch and Moody’s reacted stronger during the pandemic than following the Lehman crisis.

The seasonal profile of downgrades appears to align with the speed of the virus’s spread last spring. Yet, to us at CountryRisk.io, the overall reaction to such a profound weakening of credit fundamentals seems surprisingly mild. To assess the accuracy of this view, we contrasted rating agencies’ behaviour in 2020 with that of the 12 months following the collapse of Lehman Brothers (October 2008 – October 2009). As shown above, though still severe, the global recession back then, as well as the resulting blow to public finances were still vastly milder than what we saw in 2020. Therefore, one would also expect rating actions to have been comparably less dramatic.

To ensure a like-for-like comparison between the Lehman and COVID shocks, we need to account for the much larger sovereign ratings universe that has emerged in the years since the former crisis. As such, it would be inappropriate to simply compare the number of rating actions that followed the collapse of Lehman Brothers with the number that occurred during the pandemic. So, to reflect the increased number of rated sovereigns, we put the downgrade count into relation with the number of rated sovereigns for each agency and episode.

Chart 4 contrasts the two episodes. Overall, the Big-Three have lowered a larger share of their rated portfolio during COVID-19 than at the height of the financial crisis (20% versus 16%).

Both Fitch and Moody’s have taken more negative actions than following the collapse of Lehman and during the crisis that ensued. In the case of Moody’s this may partly reflect the observed wait-and see-attitude it had assumed during the initial stages of the global financial crisis. S&P had been the most downgrade-inclined agency during the financial crisis but became the most lenient during the COVID episode. Indeed, in a notable contrast with its competitors, S&P downgraded a lower share of its rated portfolio in 2020 than in 2009.

CountryRisk.io signals a more significant increase in sovereign risk.

In contrast to sovereign ratings issued by the established agencies, CountryRisk.io’s sovereign risk scores rely exclusively on quantitative analysis with no discretion applied by analysts.[2] Despite using standard rating symbols for comparability, the sovereign risk scores generated by our analytical algorithm are not “ratings” in the regulatory sense. CountryRisk.io does not hold a ratings license and has no intention of applying for one. What it does offer is a quick reassessment of risk as the data change.

Chart 5 shows that during 2020, CountryRisk.io adjusted many more “ratings” than the traditional agencies.

The bars display the net downgrade ratio between January 2020 and February 2021, applied to a standardised sovereign portfolio rated by all three agencies (n=106). This allows for a like-for-like comparison between those agencies and CountryRisk.io. The number of sovereigns downgraded is corrected by the number of upgrades that have occurred during the same period. The derived net downgrade ratio amounted to 12% of the portfolio for S&P and Moody’s, and around twice that for Fitch. Meanwhile, the algorithm applied by CountryRisk.io generated a net downgrade rate of over half the entire portfolio.

Once again, it is interesting to distinguish between rich and poor countries. On the standard sample of 36 advanced sovereigns, the net downgrade ratio of CountryRisk.io was 75% (see Chart 6). In other words, the net downgrade ratio for advanced economies was more severe than for emerging and developing sovereigns (51% of a standardised portfolio of 70). This is in line with the observation that, by and large, the pandemic more severely impacted advanced economies.

Chart 6 shows the opposite pattern in the rating actions of the agencies. Taking the three agencies together, the net downgrade ratio for advanced economies during the pandemic was zero.

S&P and Moody’s even displayed net upgrades for advanced economies (S&P upgraded Latvia, Lithuania and New Zealand and downgraded none; while Moody’s upgraded Greece, Lithuania, and Slovenia and downgraded the UK).

What could be the reasons for the different outcomes when comparing CountryRisk.io’s automated rating scores with ratings conducted by agencies?

One reason may be that the agencies viewed the pandemic as a transitory shock: most countries’ medium-term credit fundamentals remained unchanged. Therefore, in line with the philosophy of “rating through the cycle”, perhaps agencies saw less need to react.

Some analysts have also stressed the importance of hyper-accommodative monetary policies for public debt sustainability. Indeed, despite the increase in debt burden, the interest burden for many countries has shrunk. But implicit to this argument is the view that the current monetary stance will be maintained throughout the time horizon of a sovereign rating, which agencies typically define as up to 10 years for investment-grade issuers. That is a bold call on monetary policy. To suggest that central banks will force rates to remain at current levels for a decade assumes not only that they are able to do so, but also that the real economy will remain in crisis mode through to 2030. That scenario would not bode well for sovereign ratings. Only an environment of sustained low real interest rates and a simultaneous economic recovery would justify the absence of a more robust rating reaction for advanced economies.

Rating agencies are now much more closely supervised than they were over a decade ago, which may have led agencies to be more cautious with sovereign downgrades. For example, Steven Maijoor, chair of the European Securities and Markets Authority that supervises agencies in the EU, reportedly warned against “knee-jerk” downgrades. Instead, the agencies should time any downgrades in an “appropriate way”. Such regulatory “guidance” did not exist in 2009.

Furthermore, the fact that rating analysts of several agencies were tried (and later acquitted) in an Italian criminal court for rating downgrades during the eurozone crisis may have also affected recent decision-making, if only subconsciously. The observation that most of the analysts that had been accused were from S&P could provide clues for the relatively more cautious rating approach of that agency during the pandemic, especially towards advanced economies. As does the fact that S&P, alone among rating agencies, had been sued by the U.S. Department of Justice in 2013. Although sovereign ratings were not the underlying reason for the case brought against it, S&P said at the time it considered the lawsuit as “retaliation” for having stripped the US of it’s ‘AAA’-rating two years earlier.

Reasonable people can argue about the appropriateness of rating levels or actions. They always have. And, since ratings are opinions about the future, they always will. This is a normal and entirely healthy analytical debate. That said, it does look as though rating agencies’ overall reaction (perhaps except for Fitch) has been surprisingly mild since the onset of the COVID-19 pandemic. This observed hesitancy around ratings downgrades being particularly pronounced about advanced economies. We conclude that rating committees’ discretion has been overwhelmingly applied to the upside, keeping an otherwise looming wave of downgrades in check.

It is too early to judge whether the reluctance of raters to downgrade was the right analytical call. Indeed, there are plausible scenarios in which the pandemic ultimately leaves the creditworthiness of advanced sovereigns largely unscathed. Others will argue that such forecasts privilege hope over experience. Only time will tell. And of course, students of sovereign risk must not overlook the mounting pressure that ageing societies will pose on public finances.

What we consider somewhat unsettling, however, is that all three dominant agencies appear to have based their recent approach to sovereign ratings on comparably optimistic assumptions. This is particularly true for the two largest agencies — Moody’s and S&P — regarding advanced economies. As such, the variety and competition of credit views in the world’s largest asset class appears to be astonishingly limited. Since many investors must at least partly follow these agencies’ ratings, the lack of diversity may yet create investment risks should the agencies conclude that their hitherto optimistic outlooks need to be revised. What now looks like a downgrade trickle may yet become a torrent.

[1] The different proclivity for downgrades across agencies is unrelated to the average level of the rating. On January 31, 2020, before the spread of COVID-19, the average rating of the 106 sovereigns rated by all three agencies were all halfway between BBB and BBB- and statistically indistinguishable. S&P’s average rating was one-thirteenth of a notch lower than Fitch’s and one-fifth of a notch lower than Moody’s.

[2] CountryRisk.io’s sovereign rating model, which follows a scoring framework, considers both quantitative and qualitative indicators to capture a more comprehensive perspective of a country.

A little more than a year ago, on January 30, 2020, the World Health Organization declared COVID-19 to be a “Public Health Emergency of International Concern”. 

CountryRisk.io Blog: Taking the pulse - sovereign ratings during the pandemic

Taking the pulse: sovereign ratings during the pandemic

Our Chief Economist, Dr. Moritz Kraemer, and Lorenzo Codogno, founder and Chief Economist of LC Macro Advisors Ltd., will take stock of Covid-19’s implications on sovereigns and its rating implications. They also discuss surprising patterns on sovereign ratings since the pandemic’s outbreak last year.

Moritz will present his views on the sovereigns that are most at risk of default in 2021 and share his thoughts on why under current circumstances, debt restructurings may not be as damaging as many debtors fear.

Also on their minds: can the ECB normalize monetary conditions in the Euro area without rekindling its sovereign debt crisis?

Webinar: What has Covid-19 meant for the health of sovereigns?

Countries should not just label bonds as sustainable; they should actively tie coupon payments to sustainability targets, such as achieving its Nationally Determined Contributions on emissions.

In the midst of the greatest global economic downturn in nearly a century, governments around the world are facing an unenviable challenge — how to fund COVID-19 stimulus and relief packages while also addressing environmental degradation and climate change.

It’s not something going very well at the moment, given one new report which found that only 12% of the $14.9 trillion in global Covid stimulus financing so far is going to green projects.

Finding a solution will require outside of-the-box, innovative thinking. That’s why we at CountryRisk.io, along with a growing number of economists, investors, and policy makers, believe that sustainability-linked sovereign bonds offer an interesting opportunity for countries to build back better coming out of the global pandemic and to align the incentives of key stakeholders: governments, multilateral development banks and private sector capital.

Linking sovereign bond payments to sustainability targets

As we begin to see the light at the end of the tunnel for the Covid-19 pandemic, governments looking to stimulate green growth would be wise to consider using sustainability-linked bonds to finance a green recovery.

Sustainability-linked bonds are another financial innovation in addition to sustainability-labelled bonds. However, a key difference between the two, is that in the case of sustainability-labelled bonds (e.g. green or social bonds) the use of proceeds from the bond sale are tied to specific government expenditure (e.g. financing renewable energy power plants). In January 2020, Ecuador issued the world’s first sovereign social bond dedicated to social housing projects. The issue came with a guarantee from the Inter-American Development Bank that reduced the financing costs for Ecuador significantly.

Sustainability-linked bonds are different (to sustainability-labelled bonds) as they are issued for general budget spending but key bond features (i.e. coupon payments) are tied to sustainability targets. The International Capital Market Association’s guidance paper details process guidelines for structuring features, disclosure, and reporting of sustainability-linked bonds. We at CountryRisk.io believe this is a better approach, since a country could issue a sustainability-labelled bond for a renewable energy project and at the same time fund coal power plants with the general budget.

Obvious choices for targets are countries’ Nationally Determined Contributions (NDCs) to the Paris Agreement, particularly as nations are readjusting their NDCs this year, five years on from the signing of the Paris Agreement and ahead of the COP26 UN Climate Change Conference in November. The World Banks’ Anderson Caputo Silva and Fiona Stewart have been advocates of this approach. Other possible targets might be linked to biodiversity or social goals.

“Investors really want to push countries to be ambitious and in addition, include ways in which consequences are attached to meet targets. Sovereign linked sustainable bonds are an interesting potential way to do this.”

Issuers will also need to consider how to link sustainability performance to the bond’s coupon. One framework could feature coupon step-ups, where a higher coupon is paid by the issuer if key performance indicators (KPIs) are not achieved.

Another option could be that a multilateral development bank (MDB) like the World Bank, pays part of the coupon if the country meets the KPIs. The bond holder would always receive the same coupon, but the country’s debt servicing costs would be reduced if sustainability targets are achieved. MDBs have ample experience with such set ups and it would leverage the financial means of the MDBs through bringing in private capital.

While “sustainability-linked bonds” is a sexy new label, these bonds could be considered plain vanilla structures with some covenants related to sustainability targets. Corporate bonds — especially the lower rated segments — have always included clauses that stipulate if a company fails to reach certain targets (e.g. debt to equity ratio needs to stay below a certain threshold), the investor receives a higher coupon, or in more extreme cases, the investor can demand early repayment of the principal.

There are some sovereign bonds with embedded options that allow the investor to demand early repayment, but the more interesting bond structure to draw parallels to sustainability-linked bonds is Argentina’s GDP-indexed warrants.

Simply speaking, these warrants are structured so that the investor receives a coupon payment if the real GDP level and growth rate exceed certain threshold values. By extension, the price of the warrant reflects investors’ assessment of Argentina’s growth outlook. If investors think that the economy will grow faster, then the price of the warrant will go up. Or put differently, the price of the warrant reflects a certain future growth path.

If we were to apply this concept to sustainability-linked bonds, the market would provide information on the probability of a sustainability target being reached. For instance, we could extract from bond prices the probability of a country achieving its emission targets. One should add “in theory” as it would require quite a liquide market.

Certainly, the Argentinian warrants case highlights the challenges of defining the target and thresholds, as well as the difficulty in monitoring their performance over time. Additionally, there is precedence for inflation-linked government bonds where the coupon payment is linked to the inflation rate. Further, the market’s trust in inflation statistics varies from country to country. But these challenges are surmountable; the market can have some disciplining effect. If investors deem the KPIs issued by the authorities unreliable, demand for such bonds will be very low.

We believe that the multilateral development banks — first and foremost the World Bank — or an organisation within the United Nations, are well positioned to take the role of monitoring agents. They have ample experience in keeping track of social and environmental outcomes from decades of project financing and also have established relationships with sovereign states. Transparency regarding a country’s performance in relation to the sustainability-targets and the initial goal-setting will be crucial. So will the level of ambition. The KPIs for the bond need to be stretch targets that lead to significant advancement of sustainable development goals. This, by extension, means that the issuers and MDBs need to have high ambitions when it comes to sustainability goal-setting. Certainly, it is easy to see how politics could prevent sustainability-linked bonds from driving the positive change they are intended to bring.

Conceptionally, we view sustainability-linked bonds as more intriguing than sustainability-labelled bonds and we hope that they will also gain traction in the sovereign space. There have already been a few cases of sustainability-linked bonds at the corporate level and now the time has come for sovereigns to break new ground. Let’s wish sustainability-linked bonds roaring success!

Governments around the world are facing an unenviable challenge...

CountryRisk.io Blog: Building back better: Linking sovereign bond payments to sustainability targets

Building back better: Linking sovereign bond payments to sustainability targets

Webinar: What has Covid-19 meant for the health of sovereigns?

Jenny Asuncion
Mar 10, 2021

Taking the pulse: sovereign ratings during the pandemic

Building back better: Linking sovereign bond payments to sustainability targets

Written by:
Jenny Asuncion

Webinar: What has Covid-19 meant for the health of sovereigns?

Jenny AsuncionMar 10, 2021

Taking the pulse: sovereign ratings during the pandemic

Building back better: Linking sovereign bond payments to sustainability targets

Written by: Jenny Asuncion

Jenny Asuncion
Mar 10, 2021

Written by:
Jenny Asuncion