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Review how sovereign default risk is measured and outline what goes into a sovereign rating.

FRM® Part II · Credit Risk Measurement and Management · Country Risk: Determinants, Measures, and Implications · FRM2.CR.8.e

The idea

Sovereign default risk is measured with agency ratings, with market prices, and with fundamentals. The market prices are sovereign CDS spreads and the yield spread of a government bond over a risk-free bond in the same currency and maturity. Ratings are built from quantitative and qualitative inputs. These are the size and composition of government debt (currency, maturity, who holds it), fiscal deficits, growth, inflation, the external position and reserves, and political and institutional strength. A market spread approximates annual default probability times loss given default. Dividing the spread by the loss rate therefore gives a rough default probability, as follows. PD = spread ÷ (1 − recovery rate). A 300 basis point spread with 40 percent recovery implies roughly 5 percent a year. The usual errors are dividing by the recovery rate instead of the loss rate, and comparing yields in different currencies when computing a spread.

Formulas

Annual default probability implied by a sovereign spread

annual PD = spread ÷ (1 − R)

spread
the CDS spread or the yield spread over a risk-free bond in the same currency
R
the expected recovery rate

An approximation. Dividing by R instead of 1 − R, or using yields in different currencies, are the errors.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is a typical input into a sovereign rating?

  1. The price-to-earnings ratio of the national stock market. Equity valuation reflects corporate earnings and investor sentiment, not the government's capacity to repay.Why not: An equity valuation multiple is not an input into a sovereign credit rating.
  2. The number of companies listed on the national exchange.Why not: Market depth is not a driver of the government's ability to repay.
  3. The size and composition of government debt relative to the economy's capacity to service it. - correct
  4. The previous year's return on the national equity index.Why not: Equity returns are not a fundamental factor in the government's ability or willingness to pay.

Sovereign ratings weigh debt burden, fiscal balance, growth, external position and political and institutional strength.

A harder one

Country A has government debt of 120 percent of GDP, 90 percent of it in local currency held by domestic investors, and a current account surplus. Country B has debt of 60 percent of GDP, 70 percent in foreign currency, and a current account deficit. Which statement best explains why A could be rated at or above B?

  1. Rating agencies consider only the debt-to-GDP ratio, so B must be rated higher. Agencies also weigh debt composition, external accounts, growth and institutions.Why not: Ratings use many factors; headline debt is only one.
  2. The composition of debt (currency, holders) and the external position matter as well as the headline debt ratio. - correct
  3. Rating agencies ignore the external position, so the current account is irrelevant.Why not: The external position and reserves are standard rating inputs, especially for foreign currency risk.
  4. Debt held by domestic investors is always riskier because it can be inflated away.Why not: Local currency debt in domestic hands is generally easier to service, as the currency can be created.

Ratings combine several factors. Local currency debt held domestically with an external surplus is far easier to sustain than a smaller stock of foreign currency debt with a deficit.

The hardest tier

A sovereign has a 10-year USD bond yielding 7.4 percent and a 10-year local currency bond yielding 12.0 percent. The 10-year US Treasury yield is 4.1 percent and the 10-year local currency risk-free rate is 8.9 percent. What is the default spread on the sovereign's foreign currency debt?

  1. 7.9 percentWhy not: Subtracts the dollar risk-free rate from the local yield, mixing currencies.
  2. 3.3 percent - correct
  3. 3.1 percentWhy not: Computes the local currency spread (12.0 - 8.9), which measures local currency default risk.
  4. 4.6 percentWhy not: Subtracts the dollar yield from the local yield, which captures inflation and currency differences, not default risk.

Foreign currency default spread = 7.4% - 4.1% = 3.3%. A spread is measured against a risk-free rate in the same currency and maturity.

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