Ratings Changes, Center Country Interest Rate Hikes, Stock and Bond Returns

April 22, 2011

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First, rating changes significantly affect bond and stock markets, with yield spreads increasing on average 3 percent and stock returns declining about 1 percent  following a downgrade.

Second, rating changes also contribute to contagion or spillover effects, with rating changes among emerging markets triggering changes in both yield spreads and stock returns in foreign countries.  Still, the effect is smaller than that of rating changes of the domestic economy.

Third, similar to the findings in the literature on contagion, the “contagion” effects of rating changes are of a regional nature.

Fourth, fragile economies, as measured by the international ratings, are more severely affected by changes in U.S. interest rates.  In fact, interest rates hikes in financial centers fuel increases in sovereign risk 50 percent larger in vulnerable circumstances, relative to the changes when countries have more healthy economies.

Lastly, domestic-country rating upgrades take place following market rallies, while downgrades occur after market downturns.  Foreign changes in ratings have  a sustained effect

HistorySquared

Interest rate hikes in the US can be expected to trigger debt and currency crashes in countries that are in a tenuous state.

Downgrades that reduce a pool of investors due to investment mandates, say from investment grade to non investment grade are the most important, as are those that reveal new information, such as in opaque emerging markets.

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