Ratings Redux: The Moody's US Ratings Downgrade and Aftermath

Key Concepts

• Sovereign Ratings: Assessments of a country's creditworthiness by rating agencies like Moody's, S&P, and Fitch, indicating the likelihood of a government defaulting on its debt.
• Sovereign Default: A situation where a country is unable to repay its debts.
• Debt-to-GDP Ratio: A measure of a country's total debt relative to its Gross Domestic Product (GDP), often used as an indicator of financial health.
• Risk-Free Rate: The theoretical rate of return of an investment with zero risk, typically represented by government bond yields of highly rated countries.
• Equity Risk Premium (ERP): The excess return that investing in the stock market provides over a risk-free rate.
• Sovereign Credit Default Swaps (CDS): Financial derivatives that allow investors to "insure" against a sovereign default, providing a market-based measure of default risk.
• US Exceptionalism: The belief that the United States holds a unique and superior position among nations, often leading to a perception of special treatment in financial markets.

Moody's Downgrade of the US and Sovereign Ratings

Background of Sovereign Downgrades

The transcript begins by discussing the news of Moody's downgrading the US from AAA to AA+ on May 16, 2025. This event is framed within a historical context, noting that it was the third major rating agency to downgrade the US. S&P first downgraded the US in August 2011 from AAA to AA+, a move that caused temporary market turmoil but ultimately passed. Fitch followed S&P in 2023, also downgrading the US. Both S&P and Fitch cited two primary factors for their downgrades: the increasing debt burden of the US government and perceived political dysfunction that could lead to a default. Moody's, previously the outlier, joined the other agencies in May 2025.

Understanding Sovereign Ratings

To contextualize the downgrade, the speaker delves into the nature of sovereign ratings.

• What are Sovereign Defaults? Sovereign defaults occur when countries borrow money and are unable to repay their debts. Historically, Latin America has been an epicenter for defaults, with Europe, North America, and Australia being exceptions.
• Trends in Defaults: The frequency of sovereign defaults fluctuates with the global economy. The transcript presents data on global debt in default from 1990 to 2023, illustrating widespread defaults across the globe.
• Local Currency Defaults: A significant and puzzling trend in recent decades is the increase in defaults on local currency debt. Theoretically, governments should not default in their own currency as they can print more money. However, governments face a difficult choice: print money and risk inflation (or hyperinflation), which erodes faith in the currency, or default. Some governments opt for default, believing it is easier to recover from than hyperinflation.
• Consequences of Default: Sovereign defaults have several negative consequences:
  • A drop in real GDP (0.5% to 2%).
  • Negative impact on a country's long-term rating and borrowing capacity/cost.
  • Potential for trade retaliation.
  • Increased fragility in banking systems.
  • Increased political dysfunction and likelihood of political change.

The Role of Rating Agencies

The "big three" rating agencies – S&P, Moody's, and Fitch – are central to the sovereign ratings landscape. They adapted their corporate rating methodologies to the sovereign space.

• Growth of Sovereign Ratings: In 1985, Moody's rated only 13 countries, with 11 of them being AAA. By 2025, this number had exploded to 143 countries.
• Rarity of AAA Ratings: The number of AAA-rated countries has remained low, peaking around 15-16 in the mid-2000s. In the last 15 years, several countries, including the US, UK, Japan, and France, have lost their AAA status.
• Methodology for Assigning Ratings: Rating agencies like Moody's assess:
  • Fiscal Strength: A country's economic strength.
  • Institutional Strength: The robustness of institutions supporting borrowing, including political stability.
  • Susceptibility to Event Risk: Exposure to risks like commodity price fluctuations. Agencies typically start with quantitative factors to derive a score and then incorporate "soft factors" or "other considerations."

Global Sovereign Ratings Landscape (Early 2025)

The transcript provides a snapshot of global sovereign ratings at the start of 2025:

• Unrated Regions: Significant portions of Northern Africa and Russia (whose ratings were withdrawn in 2022) remained unrated.
• Highly Rated Countries (AAA): The US, Canada, Australia, parts of Northern Europe (e.g., Germany), and Singapore were among the few AAA-rated countries.
• Country Risk Hotspots: Latin America and Africa were identified as areas with higher country risk from the rating agencies' perspective. Asia, with China and India showing improvement, was becoming safer.
• 2025 Rating Changes: By May 2025, there had been eight rating changes (four upgrades, four downgrades). The US downgrade was the most prominent. Greece was highlighted as a success story, improving its rating over nearly a decade.

Effectiveness and Criticisms of Sovereign Ratings

The transcript examines whether sovereign ratings effectively measure default risk and discusses their limitations:

• Correlation with Default Risk: On the surface, ratings are highly correlated with default risk. Moody's data shows that AAA-rated sovereigns rarely default, while speculative-grade countries (below BA1) have a significantly higher default rate (around 24%). Investment-grade countries (BA1 and above) have a low default rate (1.8%).
• Caveats and Criticisms:
  • Upward Bias: While evidence is limited, there's a suggestion that countries paying for ratings might influence agencies to avoid downgrades. However, this is less applicable to sovereign ratings as they are not a primary revenue source, and many are unsolicited.
  • Herding Behavior: When one agency downgrades a country, others often follow, potentially reducing the collective value of ratings.
  • "Too Little, Too Late": Ratings are often perceived as lagging indicators. For example, Greece's financial troubles began in 2009, but its downgrade by rating agencies didn't occur until 2011, by which time the problem was widely known. This lack of timeliness is a concern for investors seeking forward-looking signals.
  • Exacerbating Problems: A downgrade can worsen a country's economic situation, especially for smaller, debt-dependent nations, by increasing borrowing costs and potentially triggering an economic collapse.
  • Geographic Bias: There's a perception that rating agencies are too lenient on developed markets (Europe, North America, Australia) and too harsh on emerging markets, underrating Asian, Latin American, and African countries.

Market-Based Alternatives: Sovereign CDS

The transcript introduces sovereign Credit Default Swaps (CDS) as a market-based alternative to sovereign ratings, offering a more timely measure of default risk.

• How Sovereign CDS Work: A sovereign CDS is essentially insurance against a country defaulting on its debt. Investors pay an annual premium to a seller of protection.
• Example (Brazil): If an investor buys a Brazilian government bond yielding 8.12%, they can buy CDS protection. At the start of 2025, the CDS spread for Brazil was 3.23%, meaning an annual cost of 3.23% of the bond's value for insurance.
• Advantages: Sovereign CDS markets provide constantly updated measures of default risk.
• Disadvantages: They are subject to counterparty risk and market frictions, and the numbers can be more volatile than sovereign ratings.

The US Downgrade: Rationale and Market Impact

Moody's Rationale for the US Downgrade

Moody's rationale for downgrading the US to AA+ mirrored the reasons cited by S&P and Fitch a decade prior:

• Rising Debt Levels: The US federal debt as a percentage of GDP has significantly increased in recent decades, particularly after 2008. While the trend is long-standing, the question of "why now?" arises, as the underlying debt issues were not new in 2025. The transcript notes that the debt-to-GDP ratio, while a factor considered by rating agencies, is a flawed measure of default risk, as highly indebted countries can be safe, and low-indebted countries can be risky.
• Political Dysfunction: Perceived political dysfunction was also a contributing factor.

Symbolic vs. Market Impact

The downgrade had a significant symbolic impact, but its direct market impact was muted.

• Symbolic Significance: The loss of the AAA rating from Moody's meant the US no longer held that highest rating from any of the three major agencies. The speaker argues that this signals a winding down of "US exceptionalism," where the US was previously afforded special status and could act in ways other countries could not. This symbolic shift is expected to outlast any immediate market reactions.
• Market Reaction:
  • Equities: The stock market showed minimal negative reaction. While there was a dip in the week following the downgrade, it was largely attributed to other legislative factors. By the end of May 2025, markets had recovered, indicating a null or very little effect on equities.
  • US Treasury Market: The impact on US Treasury yields was also mild. There was a small initial bump in long-term rates, but the overall change was described as "trivial."
• Reasons for Muted Market Reaction:
  • Lack of Surprise: The downgrade was widely anticipated, as S&P and Fitch had already downgraded the US, and Moody's had issued a negative outlook in November 2023.
  • "Too Little, Too Late" Phenomenon: The long lead time for rating agencies to act meant the market had already priced in much of the risk.
  • US Market Depth: The US market is characterized by immense private capital, which tends to flow into equities and debt regardless of minor rating changes.
  • Small Spread Difference: The difference in default spreads between AAA and AA+ rated countries is relatively small (0.15% to 0.2%), leading to minimal impact on borrowing costs.

Impact on Corporate Finance and Valuation

The downgrade has practical implications for financial professionals, particularly in estimating risk-free rates and equity risk premiums.

Adjusting the Risk-Free Rate

• Traditional Approach: Historically, US Treasury bond rates were considered the risk-free rate, based on the assumption of a default-free US government.
• Post-Downgrade Approach: With the US no longer AAA-rated by Moody's, the US Treasury rate is no longer definitively risk-free.
  • Example Calculation: To estimate the risk-free rate in US dollars post-downgrade (using May 30, 2025 data):
    • Start with the 10-year Treasury bond rate: 4.41%.
    • Identify the default spread for a AA+ rated country (e.g., Austria, Finland) which is approximately 0.4% (derived from comparing their Euro bond rates to Germany's or from sovereign CDS market data).
    • Subtract the default spread from the Treasury rate: 4.41% - 0.4% = 4.01%.
  • Market Anticipation: The speaker acknowledges that markets likely anticipated some default spread for the US even before the downgrade, meaning the risk-free rate might have already been implicitly lower.

Adjusting the Equity Risk Premium (ERP)

The downgrade also affects the calculation of the Equity Risk Premium.

• Pre-Downgrade ERP Estimation (Early 2025):
  • The implied ERP for the S&P 500 was 4.33%.
  • For AAA-rated countries, this 4.33% was used as a "mature market premium."
  • For countries below AAA, the US ERP was adjusted by their default spread relative to AAA-rated bonds, multiplied by 1.35 (equity being 1.35 times riskier than debt).
• Post-Downgrade ERP Estimation (End of May 2025):
  • The implied expected return on stocks for the S&P 500 was 8.64%.
  • The risk-free rate was adjusted to 4.01% (as calculated above).
  • The new ERP became: 8.64% - 4.01% = 4.63%.
• Impact on Global ERPs:
  • The US now has a higher ERP than other AAA-rated countries (Germany, Australia, Canada) because it is no longer considered AAA.
  • The "mature market premium" is now effectively 4.11% (4.63% - 0.52% US additional risk premium).
  • This means the US will have a higher equity risk premium than other AAA-rated countries, but this will be accompanied by lower risk-free rates in US dollars.

Cost of Equity Calculation Example

The transcript illustrates the impact on the cost of equity for a typical US company:

• Scenario 1: No Downgrade (Hypothetical):
  • Risk-free rate: 4.41% (US Treasury rate)
  • ERP: 4.23% (calculated using the old methodology)
  • Average risk stock (Beta 1): 4.41% + 4.23% = 8.64% expected return.
  • Safer stock (Beta 0.8): 4.41% + (0.8 * 4.23%) = 7.79% expected return.
  • Riskier stock (Beta 1.2): 4.41% + (1.2 * 4.23%) = 9.49% expected return.
• Scenario 2: With Downgrade (End of May 2025):
  • Risk-free rate: 4.01%
  • ERP: 4.63%
  • Average risk stock (Beta 1): 4.01% + 4.63% = 8.64% expected return. (Same overall return, but composition changed: lower risk-free rate, higher ERP).
  • Safer stock (Beta 0.8): 4.01% + (0.8 * 4.63%) = 7.71% expected return. (Slightly lower).
  • Riskier stock (Beta 1.2): 4.01% + (1.2 * 4.63%) = 9.57% expected return. (Slightly higher).

The overall change in expected returns is described as "almost trivial." Analysts using the US Treasury rate as a risk-free rate and an ERP over that rate can likely continue their practice with minimal noticeable difference. However, this could change if the US rating deteriorates further.

Conclusion and Future Outlook

Financial and Economic Consequences

The immediate financial and economic consequences of the Moody's downgrade are expected to be minimal due to the lack of surprise. The impact on the cost of equity will be small, and US dollar-denominated financial practices can largely continue without major changes.

The Enduring Symbolic Effect

The most significant takeaway is the symbolic shift. The downgrade signals that the US is no longer immune to the consequences of its financial and political actions and is losing its special status. This increased accountability is viewed as healthy for both the US and the global financial system. The speaker emphasizes the need to monitor this symbolic effect, as it may represent a fundamental adjustment in how the US is perceived and treated in global markets.