Why Home-Currency Sovereign Downgrades May Not Raise Yields
Summary
The exchange considers why UK government bond yields fell after Brexit-related uncertainty and a credit rating downgrade, despite the expectation that greater perceived risk should increase yields. It also mentions falling Finnish yields after a downgrade and asks whether safe-haven demand or monetary policy expectations can outweigh credit risk.
The accepted answer argues that ratings on sovereign debt in a country's own currency may be less informative because the government and central bank can create that currency to meet nominal obligations. On this view, markets may discount a downgrade when the risk of involuntary default is limited, and rating changes may reflect a weakening economy rather than a new obstacle to repayment. The explanation is a broad argument, not a complete account of yield movements: it does not quantify the roles of policy expectations, demand, inflation, or other market factors, and its claim about home-currency solvency is not universal.
Key ideas
- A downgrade does not guarantee that sovereign yields will rise.
- For debt issued in its own currency, a sovereign may have the ability to create currency to meet nominal payments.
- Ratings can reflect economic weakness even when investors see little change in repayment capacity.
- Safe-haven demand and policy expectations may also influence yields, though the answer does not measure their effects.
Tags
Full text
# Yield Curve Movement: Risk/Reward versus Safe Haven Demand & Monetary Policy Expectations # Yield Curve Movement: Risk/Reward versus Safe Haven Demand & Monetary Policy Expectations UK leaves Europe, credit rating get's downgraded. High uncertainty, higher perceived risk - based on just risk/reward, would expect yields on UK debt to increase. They did the opposite. UK government yield curve was down at all tenors after Brexit news. Assumption is that UK government bonds are still considered a 'safe haven' asset and so demand would have pushed price up/yield down. In addition, there seem to be expectations that the government will maintain a low interest rate environment to foster economic growth. Drop in yields following Brexit is explained. I took a look a Finnish yields(5 / 10 year) after their debt was downgraded on June 3rd. Same thing, yields down. Whilst their economy is under strain, this example seems to contradict logic because the only major event on June 3rd seems to be the downgrade - nothing like Brexit. Do you think it is right to assume that monetary policy / demand for safe haven assets generally have a heavier 'weight' than the risk/reward logic (worse credit rating = higher risk = higher reward needed to take that risk = higher yield) I have in my head? Is there something I am missing here?? I was expecting the opposite!! ## Answer by dm63 (score 0, accepted) https://quant.stackexchange.com/a/27848 You're missing something important. Sovereign credit ratings are very misleading when the sovereign can print its own money (like the UK). I would argue that every country is AAA in debt of its home currency, since its central bank can just print money to pay off the debts. There are examples when a sovereign chooses to default on its own currency, admittedly, but this is a choice. The rating agencies tend to downgrade sovereign debt in home currencies when countries' economies worsen, but I'm not sure it's appropriate. The markets tend to ignore those downgrades, as you have observed.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.