On the explanatory power of sovereign credit ratings

Sovereign credit ratings for developed economies have been highly volatile during the recent years of economic crisis. The extent to which these ratings affect sovereign bond yields is not clear-cut. Investigating data for Portugal, Italy, Ireland, Greece and Spain with respect to Germany, for the period 7/13/2006 – 5/14/2012, it is found that sovereign credit ratings have significant, independent explanatory power with respect to sovereign bond yield spreads, over and above their correlation with other publicly available information. The direction of the causal effect is found to run from sovereign credit ratings to bond yield spreads. Credit ratings fully capture the effect of sovereign debt; they complement the effects of contagion, ECB policy, liquidity, current account balance, GDP growth and unemployment measures.