In a measured yet significant move, Moody’s has downgraded the United States’ sovereign credit rating from Aaa to Aa1. The action emphasises the escalating apprehensions about long-termfiscal vulnerabilities, echoing similar downgrades by S&P in 2011 and Fitch in 2023. On the contrary, Moody’s has issued a modest but meaningful upgrade of India’s sovereign credit rating from Baa3 to Baa2, marking the first in fourteen years. This measure indicates an increase in confidence in India’s structural reforms, fiscal discipline, and growth trajectory.

Nonetheless, the reaction to the U.S. downgrade was marked by a tone of dismissal from some political quarters. The White House dismissed its credibility, remarking that “nobody takes his analysis seriously”, referring to Moody’s economic analyst Mark Zandi. However, such remarks often overlook the broader significance of sovereign ratings. These ratings influence Equity Risk Premium, which is essential to equity valuation and investment decisions. To comprehend that it is essential to acknowledge that the equity market is essentially a valuation mechanism. It is a forward-looking system that discounts future cash flows to determine current asset prices based on anticipated risk and return. At the core of this mechanism lies Equity Risk Premium (ERP)ss, a concept that symbolises the return investors demand for bearing the risk associated with equity investments over the relative safety of government bonds.

Sovereign Downgrades and the Fragility of Risk-Free Benchmark

U.S. Treasury bonds, in particular the 10-year note, have been regarded as the benchmark for risk-free investing by the global financial markets. Asset pricing models and valuation frameworks are grounded in the perceived reliability of U.S. Treasuries and are essential for assessing how risk is priced across markets. As a result, countries and corporations have benchmarked trillions of dollars in investment to the U.S. Treasuryyields. The downgrade revision of the sovereign credit rating casts a doubt on the sanctity and credibility of U.S. treasuries. It triggers a widespread reassessment of risk and may prompt a broader shift in investors’ assetallocation strategies in the long run. As investor reassesses not only the risk embedded in government bonds but also the premiumthat they demand for holding inherently riskier equity capital.

The shift in risk perception has an immediate ripple effect on the valuation of the companies on the stock market, notably when it comes to measures like the forward Price-to-Earnings ratio (P/E). The PE ratio reflects the current price that investors are willing to pay today for each dollar (or rupee) of anticipated future earnings. It is intricately linked required rate of return, which comprises of Equity Risk Premium. When investors perceive more risk in the market, the ERP increases, which raises the required rate of return. When the required rate of returngoes up, the future earnings become less valuable today and that usually leads to a drop in the P/E ratio. Notably,even if corporate earnings projections remain unchanged, the valuation placed on those earnings declines solely due to recalibration of the required rate of return.

The sovereign ratings beyond the valuation model also influence the behaviour of institutional and foreign investors by interacting with the regulatory requirements and internal risk-management frameworks. Large asset managers, pension funds, and sovereign wealth funds are constrained by the necessities that limit the exposure to sub-investment grade securities or require risk weighting in line with the sovereign ratings. While the U.S. retains the investment grade status, even a modest downgrade can lead to portfolio rebalancing, especially among conservative rule-based investors. Hence, this may lead to forced selling or reduced holdings, which are not always caused by changes in fundamentals but by modifications driven by compliance. Moreover, benchmark indices like MSCI, FTSE, and Bloomberg Barclays may recalibrate weightings in the global bonds and equity indices, which will result in limited passive exposure to yields and a greater risk premium for both sovereign debts and corporate borrowings. 

Also Read: Risk Management Strategies for the Modern Financial Sector

A Boost to Market Valuation and Sectoral Confidence

Conversely, India’s slight upgrade in sovereign credit rating leads to a decrease in the Equity Risk Premium by lowering the perceived country’s risk. As the ERP diminishes, the required rate of return applied to future cash flow declines, increasing the current value of expected corporate earnings and therefore resulting in a higher price-to-earnings multiple. This phenomenon is most evident for sectors such as infrastructure, technology, and consumer discretionary, where a significant portion of intrinsic value is derived from cash flows that are expected far into the future.The market effect of rating upgrades is thus increased since even a slight improvement in the perception of sovereign credit can result in disproportionately bigger improvements in valuations within these forward-looking sectors.

In sum, sovereign ratings are much more than just symbolic labels; they are embedded in the mechanism of global capital allocation, valuation models, and investors’ risk perception. This shift in the perception of risk-free assets raises a profound structural question for international finance: if the U.S. Treasuries no longer serve as the unequivocal bastion of stability in asset pricing models, then which sovereign financial instrument or what mechanism will emerge as the new foundation of global financial safety?

About the Authors

Dr. Asheesh Pandey is a professor of finance, Research Head at IIFT New Delhi, and Campus Head at IIFT GIFT City. With over 25 years of experience spanning investment banking, equity research, and academia, his expertise lies in equity valuation, portfolio management, and corporate finance. He has authored and edited multiple books and published extensively in leading national and international journals.  

Radha Kaushik is a Research Scholar at the Indian Institute of Foreign Trade (IIFT), New Delhi. A UGC-NET JRF in Commerce, she holds an M.Com in Finance from the Delhi School of Economics and is studying equity valuation, currency, and global market dynamics.