Last Updated: 27 January 2023
There’s a big difference between some of the sovereign credit ratings given by ratings agency Standard & Poor’s and those derived from the credit derivatives market, with the credit market’s assessment of sovereign risk in certain Eurozone countries substantially more pessimistic than that of the agency.
Standard & Poor’s “domestic” rating for a bond issuer reflects the agency’s opinion of the debtor’s willingness and ability to service its financial obligations on a timely basis, regardless of the currency denomination of those obligations. S&P also publishes foreign currency ratings, which give the agency’s opinion of debt issuers’ willingness and ability to repay foreign currency obligations.
By contrast, the “CDS-implied” ratings calculated by credit market data specialist CMA are intended to allow a comparison of the credit derivatives market’s assessment of an entity’s credit ratings with that of S&P. As their name suggests, CDS-implied ratings take as a starting point the probability of default that’s implied by prevailing market rates for credit default swaps (CDS). This default probability is then converted into a rating that allows comparison with a typical ratings agency scale of default risk. The comparison then enables investors to evaluate whether the scale of any differential is merited, as well as permitting investors to take action before any change in the “official” rating occurs, according to CMA.
CMA points out that the credit derivatives market often reacts more promptly to perceived changes in credit risk than the rating agencies. The agencies tend to take a broader and sometimes qualitative view of an entity’s default risk, CMA says. This makes the CDS market a useful guide when monitoring an entity’s changing default probability, the firm adds.
Based on the CDS-implied ratings supplied by CMA on Friday November 25, there are some striking differences between the credit market’s current assessment of default risk and the credit assessment as given by Standard and Poor’s.
In the table on page 2 the CDS-implied rating for each sovereign debt issuer is given in the first column after the relevant country’s name. S&P’s current long-term domestic credit rating for that issuer is given in the middle column.
Then, based on a simple ranking of credit ratings from the highest (AAA = 1) to the lowest recorded in the table (CCC- = 19), any difference between the CDS-implied rating and the S&P ratings score is given in the final, right column. The absolute value of this difference reflects the number of “notches” on the ratings scale between one rating and the other.
Where the CDS-implied rating is better than that given by S&P, the difference is a positive number. When the CDS-implied rating is worse, a negative number is the outcome. All positive differences greater than or equal to five notches are shown in blue; all negative differences of five notches or more are given in red.