Sovereign Credit Rating: Definition, How They Work, and Agencies

What Is a Sovereign Credit Rating?

A sovereign credit rating is an independent assessment of the creditworthiness of a country or sovereign entity. Sovereign credit ratings can give investors insights into the level of risk associated with investing in the debt of a particular country, including any political risk.

At the request of the country, a credit rating agency will evaluate its economic and political environment to assign it a rating. Obtaining a good sovereign credit rating is usually essential for developing countries that want access to funding in international bond markets.

Understanding Sovereign Credit Ratings

In addition to issuing bonds in external debt markets, another common motivation for countries to obtain a sovereign credit rating is to attract foreign direct investment (FDI). Many countries seek ratings from the largest and most prominent credit rating agencies to encourage investor confidence. Standard & Poor's, Moody's, and Fitch Ratings are the three most influential agencies.

Other well-known credit rating agencies include China Chengxin International Credit Rating Company, Dagong Global Credit Rating, DBRS, and Japan Credit Rating Agency (JCR). Subdivisions of countries sometimes issue their own sovereign bonds, which also require ratings. However, many agencies exclude smaller areas, such as a country's regions, provinces, or municipalities.

Sovereign credit risk, which is reflected in sovereign credit ratings, represents the likelihood that a government might be unable—or unwilling—to meet its debt obligations in the future. Several key factors come into play in deciding how risky it might be to invest in a particular country or region. They include its debt service ratio, growth in its domestic money supply, its import ratio, and the variance of its export revenue.

Many countries faced growing sovereign credit risk after the 2008 financial crisis, stirring global discussions about having to bail out entire nations. At the same time, some countries accused the credit rating agencies of being too quick to downgrade their debt.

The agencies were also criticized for following an "issuer pays" model, in which nations pay the agencies to rate them. These potential conflicts of interest would not occur if investors paid for the ratings.

Sovereign credit ratings may also fall due to political turmoil. For example, in 2023 Fitch Ratings downgraded the United States' credit rating from AAA to AA+, partially due to a "steady erosion in standards of governance" over the previous two decades. This deterioration resulted in repeated last-minute debt ceiling negotiations that raised the possibility that the government might default on its debts.

Examples of Sovereign Credit Ratings

Fitch gives a BBB- or higher rating to countries it considers investment grade, and grades of BB+ or lower are deemed to be speculative or "junk" grade. Fitch gave Argentina a CC grade in 2023, while Chile maintained an A- rating. Standard & Poor has a similar system.

Moody’s considers a Baa3 or higher rating to be of investment grade, and a rating of Ba1 and below is speculative. Greece received a Ba3 rating from Moody's in 2023, while Italy had a rating of Baa3 negative. In addition to their letter-grade ratings, all three of these agencies also provide a one-word assessment of each country's current economic outlook: positive, negative, or stable.

Sovereign Credit Ratings in the Eurozone

The European debt crisis reduced the credit ratings of many European nations and led to the Greek debt default. Many sovereign nations in Europe gave up their national currencies in favor of the single European currency, the euro. Their sovereign debts are no longer denominated in national currencies.

The eurozone countries cannot have their national central banks "print money" to avoid defaults. While the euro produced increased trade between member states, it also raised the probability that members will default and reduced many sovereign credit ratings.

The Bottom Line

A sovereign credit rating is a measurement of a government's ability to repay its debts. Just like personal credit scores, a high credit rating indicates that a government with low credit risk, and a low rating indicates a government that might struggle to repay its debts. Because these ratings affect the interest rates on government bonds, many countries place a high priority on keeping a high sovereign credit rating.