The joint dynamics of sovereign ratings and government bond yields

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Can a negative shock to sovereign ratings trigger a cycle of rising government bond yields and further downgrades, potentially leading a country toward default? Public discourse and some studies suggest this scenario. This paper investigates the existence of such a cycle and finds no evidence of a detrimental long-run equilibrium or a negative feedback loop leading to default, except in cases of extremely poor ratings. Utilizing a bivariate semiparametric dynamic panel model, we analyze the joint dynamics of sovereign ratings and government bond yields. The individual equations resemble Pesaran-type cointegration models, enabling valid inference regardless of unit-root behavior. We account for various empirical features documented in the literature, allowing for different long-run relationships in both equations, nonlinearities in ratings' effects, and asymmetric impacts on ratings and yields. Our results indicate a single stable equilibrium, suggesting that ratings and yields converge slowly toward this state. However, the persistence of ratings means that a shock can incur significant costs if it occurs at speculative levels or lower. Rating shocks that push ratings below this threshold can sharply increase interest rates for extended periods. Nevertheless, simulation studies indicate that it is unlikely rating agencies are responsible for the most severe spikes in interest rates.