Much ado about nothing: Sovereign ratings and government bond yields in the OECD

In this paper, we propose a new method to assess the impact of sovereign ratings on sovereign bond yields. We estimate the impulse response of the interest rate, following a change in the rating. Since ratings are ordinal and moreover extremely persistent, it proves difficult to estimate those impulse response functions using a VAR modeling ratings, yields and other macroeconomic indicators. However, given the highly stochastic nature of the precise timing of ratings, we can treat most rating adjustments as shocks. We thus no longer rely on a VAR for shock identification, making the estimation of the corresponding IRFs well suited for so called local projections - that is estimating impulse response functions through a series of separate direct forecasts over different horizons. Yet, the rare occurrence of ratings makes impulse response functions estimated through that procedure highly sensitive to individual observations, resulting in implausibly volatile impulse responses. We propose an augmentation to restrict jointly estimated local projections in a way that produces economically plausible impulse response functions. We develop a semiparametric local projections method where smoothness can be imposed as constraint without assuming a specific functional form. The degree of smoothing can be assessed using a standard information criterion. While rating downgrades can play some role, we find no evidence for an impact of ratings in the most critical case of countries that are unusually well rated compared to their debt situation. Rather, ratings seem to be adjusted when the market evaluation of the risk associated with the high level of debt has already peaked.