How a sovereign credit rating shapes borrowing costs

A sovereign credit rating is a letter grade on a government’s ability to repay its debt. Three agencies, S&P, Moody’s and Fitch, dominate the market, and their grades run from AAA at the top down to default. The notation differs slightly between them.

The grade matters well beyond the finance ministry. It sets how much it costs a country to borrow. This explainer sets out how the grades are assigned, what moves them, and how a change reaches bond markets and banks.

What a sovereign rating measures

A 2015 study in the Bank for International Settlements Quarterly Review by Amstad and Packer describes ratings as opinions on the relative likelihood of default. They look ahead two to three years and are meant to be “through the cycle”, so they are not supposed to swing with every market move.

Agencies assess both ability and willingness to pay. That is why institutional strength and the rule of law carry weight alongside economic data.

The scale is split by one dividing line. Investment grade runs from BBB- upward, and BB+ and below is speculative, often called junk. One overview of the market says a little over half of roughly 130 rated governments are investment grade, but its country table lists 67 of 146 as investment grade.

Calendar rule
Under Article 8a of the CRA Regulation, as ESMA’s Q&A describes it, sovereign rating and outlook dates should fall on a Friday, and unsolicited sovereign ratings are limited to three publication dates.

How the three agencies assign grades

According to the BIS study, the agencies’ methodologies mostly take the form of scoring systems with limits on how much each factor can weigh, and they leave room for analyst judgment. Since the financial crisis the agencies have leaned more on quantitative inputs.

The BIS authors report that Moody’s introduced a methodology in 2008 that put more weight on quantifiable factors and refined it in 2010, and that S&P added quantifiable factors in 2011. At the time of the study, Fitch used a foreign-currency rating model based on 19 economic and financial variables.

The authors also ran their own regressions on what drives the grades. Those give a sense of scale, though they are estimates and not agency formulas. Every 10 percentage points of debt to GDP lowered a rating by 0.2 notches before the crisis and 0.3 afterwards.

Debt affordability also mattered. Every 10 points of interest payments relative to revenue lowered a rating by 0.7 notches before the crisis and 1.2 afterwards. A past default cost close to two notches before the crisis and 2.5 notches in 2015.

On the other side, foreign-exchange reserves worth 10 percentage points of GDP added 0.4 notches. A 10% rise in per-capita GDP added 0.15 notches in 2015.

What has gained and lost weight

The BIS study found that some factors rose in importance after the crisis. These were the monetary regime, including membership of a currency union, and the international use of a country’s currency. Event risk and contingent liabilities, financial cycles such as credit booms, and growth performance and potential also gained weight.

Some agencies place less emphasis on per-capita GDP. Exposure to foreign-currency debt became statistically insignificant. Institutional strength and reserves relative to GDP stayed of similar importance.

The authors also looked at whether emerging economies are marked down unfairly. In a simple regression on debt burden, EME status was associated with a rating about eight notches lower in both 2007 and 2015. Once other variables were included, the penalty fell below one notch and was statistically insignificant.

Interest costs can differ sharply from debt levels. The study cites Turkey, with gross debt just above 30% of GDP and net interest over 3% of GDP, against Japan, with gross debt well above 200% of GDP and net interest of 1.5% of GDP.

What triggers an upgrade or downgrade

In the BIS regressions, higher debt, a heavier interest burden and a default history were associated with lower ratings, and higher foreign exchange reserves with higher ratings.

The BIS study traced the post-crisis pattern to 2015. The average rating for advanced economies fell from AA+ to AA- after mid-2007. Advanced European economies fell three notches on average, from AA+ to A+. Greece dropped from A to CCC and Italy from AA- to BBB. The average for emerging economies was mostly stable.

Recent actions show movement in both directions. Moody’s cut the United States from Aaa to Aa1 in May 2025, after S&P’s 2011 downgrade and Fitch’s in 2023, so the overview says all three rate it AA+. Fitch cut France to A+ in September 2025 and S&P did so in October 2025, while Moody’s put its Aa3 rating on negative outlook.

The overview says Greece is back in investment grade at BBB and cites a Fitch upgrade in November 2025. The same overview says S&P upgraded India to BBB in 2025, its first S&P upgrade of India in 18 years. It says Indonesia was affirmed at BBB in July 2026 and does not name the agency.

A fall from BBB- to BB+ matters far more than a cut from AA to A, because many funds can hold only investment-grade debt and must sell when a country drops below the line.

When ratings change in Europe

EU rules limit when agencies may act on sovereigns. ESMA’s published Q&A says that at the end of each December, agencies must send ESMA a calendar of sovereign rating and outlook dates for the next 12 months, and publish it on their websites.

Publication dates for sovereign ratings and related outlooks should be set on a Friday. For unsolicited sovereign ratings, the number of publication dates is limited to a maximum of three dates.

The rules took effect on 20 June 2013, and Friday publication applied from the first Friday of January 2014. The ESMA page does not address exceptions to the calendar.

How a change reaches bonds, banks and companies

One route is the government bond market. The overview says crossing into junk can cause a country’s borrowing costs to spike. A fall from BBB- to BB+ matters far more than a cut from AA to A, because many funds can hold only investment-grade debt and must sell when a country drops below the line.

Size matters too. According to the same overview, single-notch cuts above that line in deep markets often move yields only modestly, as seen with the United States and France in 2025.

Banks are the second route. The overview notes that bank capital regulations penalise junk debt. The sources reviewed do not give figures for bank or corporate borrowing costs.

Markets also move ahead of the agencies. The BIS study found credit default swap spreads are much more volatile than ratings and move together more closely than ratings across emerging economies, which the study links to swings in global risk appetite. Recently, downgrades have tended to follow spread increases rather than lead them.

Interest rates in the wider economy matter as well. The study says low post-crisis policy rates cut borrowing costs and indirectly supported advanced-economy ratings. It estimates that a return to 2007 rates would roughly double the interest burdens of the major advanced economies.

The overview does not discuss the effect on currencies.

Photo: Tim Sheerman-Chase · CC BY 2.0 · via Wikimedia Commons