Why corporate borrowers need to track credit default swap rates

Ratings, however, matter more to Indian companies that borrow from abroad, given that India’s sovereign rating serves as a ceiling on their own rating. A company can get a rating up to two notches higher than the sovereign in case its global operations justify it.

One way to view the impact of sovereign ratings on companies is to look at the interest rates they are asked to pay on their borrowings. Here, sovereign credit default swaps (CDS) are the key, as all private borrowing is benchmarked against these swap rates.

A CDS is essentially a form of insurance taken by an investor while investing in a security where the CDS seller provides cover in case of a default. The swap rate, which is denoted in basis points, is the premium to be paid for the cover. Sovereigns are not usually expected to default, but sovereign CDS rates serve as anchors to assess the probability of a default by any entity operating in that country. These rates are based on actual transactions and hence reveal the market’s view.

Globally, CDS rates are available for several countries. For Sweden, Germany, Australia and the Netherlands, for instance, all rated AAA, the CDS rate range was between 8 and 11 basis points (bps) on 8 September, according to World Government Bonds. On the other end, for Turkey, rated BB-, the CDS rate is as high as 263bps. India, rated BBB, has a CDS rate of 95bps. These rates vary daily, just like stock prices, but remain mostly within a small range. Besides these, there also are country ratings that are referred to.

These CDS levels reveal some interesting points. First, the difference in CDS rates between AAA and BBB rated countries is between 30bps and 85bps, which is very wide. Second, even within a band, there is considerable variation in the CDS spread. Canada, with 40bps, has a much higher CDS rate than Germany, for instance. That’s because it is still in the throes of the tariff hit by the US and is seen to be more vulnerable.

The same is true of India, which has been hit with a high tariff of 50%, far greater than similarly rated Greece and Indonesia. It is important to note that S&P did not see this as a significant challenge when it upgraded India’s rating.

Third, the US has a higher CDS rate (36bps with a AA+ rating) relative to Finland and South Korea (under 21bps) due to uncertainty over GDP growth caused by its tariff war with the rest of the world.

Fourth, China’s considerable economic power has helped keep its CDS rate under check at 41bps, which is marginally higher than that of the US even though its credit rating is two notches lower at A+.

Fifth, Israel, which has a rating of A, has a 73bps CDS rate, almost the same as Indonesia and much higher than Greece, even though the latter two have ratings three notches below. Clearly, the war in West Asia is a driving factor in the market.

Sixth, once a credit rating goes below investment grade, which is BBB-, CDS rates rise substantially. Last checked, they vary significantly across the three countries in that category: Brazil, South Africa and Turkey. Turkey has the highest, as it is probably the most fragile among the three, given its high inflation and interest rates, coupled with high unemployment and a weak currency.

Interestingly, the probability of default, which is calculated at a theoretical level, can vary from less than 0.2% for an AAA-rated country to 1.4% for India. If one’s rating falls to a sub-investment grade, the probability of default rises to 2.5-3% and is nearly 5% for Turkey.

A major takeaway from CDS spreads is that financial markets view the credit worthiness of a sovereign through a wider lens than rating agencies. Market assessments appear to assign the overall geopolitical situation and economic conditions greater weight, so CDS spreads are driven by these factors.

A rating alone is rarely a clinching factor. To this extent, it can be said that the market is more discerning and does not take agency ratings at face value while evaluating risks on its own. This is why it is essential for every country to keep its economic house in order, including variables such as inflation, currency and interest rates.

In fact, issues such as the debt of a country— which dominates the assessment of rating agencies focused on the concept’s rationale—would be taken as an institutional factor that cannot change in the short run. However, swap rates incorporate all current economic conditions, covering both the polity as well as policies being pursued and immediate challenges being faced.

With sovereign CDS rates becoming virtual market benchmarks, companies that borrow money would find their capital costs gravitating towards these limits. In other words, there is clearly merit in striving for a higher rating. For this, a consistent economic performance can be combined with a dialogue with rating agencies. There is potentially a CDS gain of 10-20bps for every upgrade notch. This could mean a lot for Indian borrowers.

These are the author’s personal views.

The author is chief economist, Bank of Baroda, and author of ‘Corporate Quirks: The Darker Side of the Sun’