to incorporate the changing risk situations, allowing investors to revise their investment plans. Obviously the usefulness of these ratings depends on the comprehensiveness of the analysis and the timeliness of the updates. As discussed later in the paper, factors contributing to the failure of ratings are broadly the same whether it is sovereign or sub-sovereign.

# **3.2  Credit Ratings and Spread**

Good credit ratings can translate into lower borrowing cost as reflected in the lower spread of the debt instrument. Various studies have shown the negative relationship between credit ratings and spreads by using benchmark sovereign bonds (say 10 years) of various countries (both developed and emerging) against credit ratings.

Sy (2002) uses panel data estimation (1994-2001) of secondary market sovereign bond spreads and ratings in seventeen emerging market economies using EMBI+<sup>16</sup> for calculated spreads and S&P and Moody’s announced country credit ratings. The study finds a negative correlation between the sovereign spreads and assigned ratings, i.e., higher ratings are associated with lower spreads and vice versa. It also finds that dispersion of spreads increased during the financial crises of 1998, demonstrating that there is increased discrimination among the countries during a crisis and that spreads are not fully based on the assigned countries ratings. The findings suggest that the market participants rely on additional explanatory variables (e.g., trading strategies, volume or bid ask spreads and other market factors) in addition to ratings.<sup>17</sup> Using unbalanced panel data, the same study finds that a one-notch upgrade by rating agencies reduces sovereign spreads on average by 14 percent (or 70 basis points for an initial spread of 500 basis points). The findings are confirmed by Rowland (2005).

Reisen and Maltzan (1999) examine the links between sovereign credit ratings and dollar bond yield spreads over the period from 1989 to 1997. This study follows the market trends for 30 days before and after rating announcements and uses the Granger causality test (which corrects for joint determinants of ratings and yield spreads). They conclude that changes in sovereign ratings are mutually interdependent with changes in bond yields and that the risk assessment by the three leading rating agencies is preceded by a similar change in the market assessment of sovereign risk.

> 16 EMBI+ (Emerging Market Bond Index Plus) is J.P. Morgan calculated sovereign bond spreads. These indices show countries weighted averages of all traded external currency denominated debt instruments in the emerging markets. Rather than traditional spreads over the US Treasuries, they control for floating coupons, principal collaterals, and rolling interest guarantees etc.

> 17 In the Article in the Journal of Banking and Finance “An Introduction to Recent Research on Credit Ratings” 2004, it has been also mentioned that “One of the earliest branches of the literature explores the relationship between credit ratings and bond prices or spreads. That literature has generally found that ratings are strongly correlated with credit spreads, but many other factors are also important.”

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