Since peaking in July, yields on Italian and Spanish long-term bonds have dropped by about 150 basis points. While the headlines attribute this sharp adjustment to the availability of a new ECB bond buying program, neither country has expressed an intention to use it, so perhaps the headline writers are missing something. Looking back, our July 23rd research note concluded that the spread between Italian and German bond yields was excessive given the low probability of an Italian sovereign default.
A Problem of Information
Market volatility is compounded when market participants lack the information necessary to appropriately value investment securities. When rumors and announcements penetrate the information vacuum, investors often overreact. If this vacuum is instead filled with high-quality information and analysis, volatility and mispricing diminish.
Equity market investors can obtain research and analysis from numerous banks and brokerage firms. While much of this research suffers from conflicts of interest, it also contains large volumes of fact and analysis that investors find useful.
For government bonds, the traditional source of analysis has been the major credit rating agencies. Unfortunately, these firms have faced widespread criticism in recent years, leaving their reputations in tatters and their guidance in doubt. Although the highest profile failures have been in structured finance, critics have also questioned whether incumbent rating agencies have sufficient staffing and resources, adequate procedures, and the intellectual capability to meaningfully gauge sovereign default risk.
Potential Ways Forward – A Call to Academics
A number of parties have recommended alternatives to the incumbent rating agencies, including at least four not-for-profit initiatives offering sovereign ratings.
To have a beneficial impact, a non-profit rating agency will have to gain credibility with investors. After all, if ratings don’t guide investment decisions, what value do they have? A not-for-profit credit rating agency can gain credibility by having a strong methodology and solid institutional support. Both of these factors can be advanced by the academic community. Economists, political scientists, statisticians and financial engineers associated with a major university could generate the kind of quality, branded sovereign research that would command the attention of investors.
In hopes of focusing more academic attention on government credit risk, I have contributed an article to the new issue of Economics Journal Watch – a peer-reviewed economics journal freely available online. The article describes problems with the rating agency model, surveys some of the previous literature on government default probability modeling, and offers a research agenda as well as one possible solution.
Academics can deliver the intellectual rigor missing from both status quo rating analysis and some of the alternatives we have been seeing. The thorough data collection procedures, advanced modeling techniques, and peer review practices employed by social scientists can raise the level of sovereign risk analysis.