How Changes in Countries' Credit Ratings Have Affected Their Stock Markets

Prior to Standard & Poor's downgrade of the U.S. government credit rating, the financial media was filled with gurus forecasting that a downgrade would result in both higher interest rates and lower stock returns. While U.S. stocks have retreated, it seems likely had more to do with the European crisis than the downgrade. And yields on U.S. government securities fell sharply.

Like with many other investment issues, myths tend to arise without historical support. Fortunately, we can take a look at the evidence on how credit downgrades impact both bond and stock markets. The short answer is that results are mixed, and that many other factors affect a country's cost of capital and stock market returns.

Bond Market Impact The AllianceBernstein study "When 'Risk-Free' Isn't Risk Free: The Impact of a U.S. Treasury Downgrade" looked at sovereign credit rating downgrades since 1990 and found that bond yields changed little among countries downgraded from AAA. Examples include Australia (1986), Canada (1992) and Japan (1998). However, countries with lower credit ratings (single A or below) experienced significant interest rate increases following their downgrade.

Stock Market Impact Unfortunately, history doesn't provide much in the way of guidance. Below is a chart that summarizes stock market performance of respective countries before and after a ratings change. It's based upon a study of ratings changes made by Moody's from 1983 to 2009. During the 27-year period, the ratings agency made 71 upgrades and 25 downgrades to governments in the developed and emerging markets tracked by MSCI.

The study identified the date of each change and logged each country's market performance in the 12 months before and after the event. Each country's market returns were compared to the respective market index and the excess return averaged for all events. (Excess return refers to performance above or below the respective market index, either the MSCI EAFE Index or MSCI Emerging Markets Index, as appropriate.) The table reports the return of an equal-weighted, event-time portfolio.

We can draw two conclusions from the table. First, markets adjust prices in response to new information much faster than agencies adjust ratings -- aggregate results show that stock markets of upgraded countries outperformed their respective market index in the 12 months before the rating change (13.83 percent), while stocks in downgraded countries aggregately underperformed the market index before the event.
Second, in the 12 months following a ratings change, relative performance was virtually identical for the upgraded and downgraded countries (3.87 percent versus 3.73 percent).

The bottom line is that the results demonstrate that markets are highly efficient, reflecting all available information and expectations about a country's economic prospects -- including the possibility of a ratings change. By the time a country's debt rating is upgraded or downgraded, the market has already integrated the news into prices. Stock markets reflected positive economic developments prior to a ratings upgrade and negative developments before a ratings downgrade. After the event, markets didn't appear to perform much differently, in aggregate.

The bottom line is that you should look to the markets for signals about the fiscal health and prospects of a country. Markets clearly work faster and more accurately than ratings firms to assess a country's financial condition and evaluate the potential impact on its cost of capital and equity market. That's why my firm never relies solely on credit ratings and pays attention to how the market perceives particular bonds. For instance, if a single A-rated bond carries the yield of a BBB-rated bond, we would avoid it (believing the market over the rating agency), while others would buy it, thinking it is a bargain.

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