Credit Risk and Rating of Sovereign Debt

As we have learned earlier, the investors in bonds are exposed to credit risk as there is a chance that the issuer may default on its obligations. Even though the general perception is that the bonds issued by the government are considered free of default, in reality all bonds expose the investors to credit risk. They are sometimes also referred to as risk-free bonds. The sovereign bonds issued by other country’s governments also have credit risk. To assess the credit risk in these bonds, the rating agencies such as Standards and Poor’s assign sovereign ratings to the bond issues. Sovereign ratings provide an opinion of the level of risk of the investing environment in a country.

There are two types of ratings for sovereign debt:

• Local currency debt rating: This is the rating assigned to bond issues in local currency. Local currency ratings refer to an entity's ability and willingness to meet all of its financial obligations on a timely basis, regardless of the currency in which those obligations are denominated and absent transfer and convertibility restrictions.
• Foreign currency debt rating: This is the rating assigned to bond issues in foreign currency. Foreign currency ratings refer to an entity's ability and willingness to meet its foreign currency denominated financial obligations as they come due.

Default rates are traditionally higher for foreign currency debt compared to local currency debt. This is because if the government can raise taxes, it would be able to generate enough local currency to fulfil its local currency debt obligation. The same is not true for foreign currency-denominated debt because the government will have to purchase foreign currency to meet its foreign currency debt obligation. This may lead to depreciation of local currency.

While assigning ratings, the rating agencies consider many factors such as economic risk, political risk, fiscal and monetary flexibility, government’s existing debt burden, external liquidity, and so on.