Sovereign Rating Methodology
Sovereign Rating Methodology
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Country risk includes the credit risk of all borrowers involved in cross-border foreign currency debt and investments in a country, while sovereign risk includes only the risk of the government (sovereign) fulfilling its obligations in a timely manner. From this perspective country risk and sovereign risk are not exactly synonyms and country risk rating and the sovereign risk rating are substantially different concepts. However, country risk is a larger cluster that includes sovereign risk and covers the assessment of all borrowers, including the private sector within the country. The country risk concept necessitates to examine many factors such as political and economical aspects together with legal regulations and also to evaluate the investor rights and gains.

Besides, country risk and the sovereign risk are closely connected since country risk’s most important determinant is the actions and decisions of the central government. The central government have a determinant role to determine the application of the exchange controls of the country and the transferability and convertibility risks. Central governments have the determining role of transfer and convertibility risks with the implementation of foreign exchange controls of the countries. Country risk; includes the transfer and convertibility risk that the debtors in the country might face in paying their foreign debts, as well as the risk of going beyond the rules of internationally accepted law, such as the risk of government seizure of private assets, changes that can be made in the tax system or company law.

The transfer risk, is being defined as the risk private persons and corporate not being able to pay their cross-border debts based on the decisions and limitations of the governments. However, transfer risk is a risk that non-public debtors, namely private sector debtors, are exposed to and does not directly concern central governments. Because governments and in general the public institutions debt, not because of the transfer risk but due to the foreign currency problem they have fallen into or are unable or unwilling to repay or delay. Because generally governments and public institutions cannot pay their debts, not because of transfer restrictions, but because of the foreign exchange problem they are in or because they are not willing to pay. Country risk, with a very general definition, basically the sum of;  

•    Transfer risk, 
•    The central authority risk, 
•    The high credit risk(the very high growth rate of the loan portfolios in the banking sector and the probability of the risk of default increasing in such a way leading to systemic risk) in countries.


Within JCR ER methodology, the highest authority level in a certain region is governments or put in other words can be interpreted as the government and the country’s central bank and other public institutions agents.  Therefore, countries' Central Banks and other public institutions can be rated at different levels, and sovereign ratings play an important role in countries' access to international capital markets.

Within the scope of the JCR ER methodology, the duties and obligations of governments to their citizens arising from the state of being a government and the obligations of state institutions towards each other are out of the scope of rating. From the perspective of rating, the sovereign rating is limited with their liabilities towards governments and toward the liabilities of private debtors. Sovereign rating; is limited by the obligations of states and their obligations to private creditors. The sovereign ratings; 

•    Denominated in local currency and  
•    Denominated in foreign currency 
are being stated in two different categories. 

International currency ratings; refers to the willingness and ability of governments to meet their foreign exchange obligations. The ability of governments to meet their foreign currency liabilities is directly proportional to the foreign currency creation capacity of the country's economy. The foreign currency incomes of countries are in general created by the export of goods and services of private companies and foreign currency investments made by foreign investors. Governments, on the other hand, buy foreign currency brought to the country by private individuals and companies from the market in order to pay their foreign currency debts.  For this reason, both local currency and foreign currency ratings are closely associated with the overall economic performance.


Local currency ratings, on the other hand, reflect the willingness of governments to pay, rather than their ability to pay. The government’s main income consists of tax and similar sources denominated in local currency. In case of insufficient local currency revenues, they can use the power to raise tax rates or borrow money from local capital markets or, if necessary, they can use short-term advances from Central Banks or the privilege of printing money.

The factors used by JCR ER in assessing the credit risk of sovereigns or governments are focused on the solvency of public debt and have been created to determine the solvency and willingness of governments separately. The main characteristics of these factors; 

•    The central governments capability to pay debt, 
•    The general macroeconomic indicators,
•    Macroeconomic performances, 
•    Public internal and external debt and its structure, 
•    The need for internal and external financing,
•    The financial sector’s structure,
•    The openness of the economies, 
•    The economic growth indicators, 
•    The capability to collect tax                                                                                                         
are directly related with those financial and structural main indicators. It is very important to clearly identify issues such as the structure of the financial sector, its fragility and the possibility of creating a future burden on the central government, which are among the structural factors.  


On the other hand, inflation, exchange rate and interest levels are also among the rating factors in the ratings of central governments, as inflation and low exchange rate and interest volatility cause an increase in government revenues and thus facilitate the solvency of public debts. 

A significant part of the foreign debts of the states are paid in foreign currency purchased from the market. For this reason, the stability in the exchange rates is considered as a factor that reduces the exchange rate risk. Within this scope

•    The foreign currency income level, 
•    Import and export balance,
•    The ratio of debt payments to export income,
•    The amount of foreign currency reserves and the import coverage ratio, 
•    Budget                                                                                                                                       
indicators measuring the short-term currency liquidity are being used in the risk assessment. While the openness of the economy is positive in terms of the increase in foreign trade and its effects on growth, it is highly correlated with the rating grades as a factor that can have negative effects in terms of exposure to sudden capital outflows. In today's world where capital movements are accelerating, the risks of governments to restrict capital outflows in such cases are considered as a part of transfer risk in order to prevent global investors from collectively transferring their capital across borders due to negative expectations and the vulnerabilities they will create in countries.  
In terms of longer-term factors, the course of economic development supported by foreign capital, the efficient use of foreign currency provided in this way and the payment of foreign debts come to the fore.  Within this scope;

•    The economic growth rate, 
•    The investments to GDP ratio,  
•    The export to GDP ratio, 
•    GDP per capita, 
•    Price movements, 
•    The composition and level of the international capital flows to the country,   
•    Default history                                                                                                                             
and other similar indicators are being used as input for rating.
In addition to the above-mentioned quantitative factors for the determination of the central government's debt payment capacity, qualitative factors are also used in the JCR ER methodology to measure the governments' desire and willingness to pay debts. Among the qualitative factors;

•    The general political risks, 
•    The political will of governments to use the resources they have in the repayment of their debt, 
•    The predictability of the economic policies,  
•    War or regime change,  
•    The stability of the government and the political authority,   
•    The accordance with law, 
•    The investment environment,
•    Transparency in politics and its applications,  
•    Anti corruption implementations, 
•    Internal/External disorder,  
•    The bureaucracy,
•    The level of socio economic pressures that might arise due to demographical reasons   
Such risks are among important factors to be considered. 
Debt Instruments Rating 
In the JCR ER methodology, corporate credit ratings of firms, central governments, local administrations, public enterprises, financial institutions and similar issuers are taken as the basis for rating debt instruments. Corporate credit ratings already include specific, systemic, transfer and convertibility risks. Therefore, on top of the corporate credit rating the debt instruments;

•    Guarantee structure,  
•    Being insured or not, 
•    Being under a guarantee scheme or not, 
•    Maturity, 
•    The level of protection of the investors                                                                                         
being evaluated separately, the results being calculated from these factors are being added to the corporate credit rating and do form a new independent rating for the debt instruments. If there has not been established a guarantee structure for the debt securities, the credit rating and the issuance rating are generally at a similar level. In this context; except the stock securities and the perpetual bonds, the capital instruments which might be issued as debt instruments or securities in general differ among them according to the rights, possibilities, risks, the issuer institution, the issuers guarantees have been stated as below.      

1.    Bonds
1.1.    Government bonds and Treasury bonds 
1.2.    Secured and Unsecured Bonds
1.3.    Bonds with Premium, Bonds at par
1.4.    Lottery Bonds  
1.5.    Participation Bonds
1.6.    Fixed and Floating Interest Rate Bonds
1.7.    Registered and Bearer Bonds
1.8.    Bonds Convertible with Securities
1.9.    Convertible Bonds

2.    Profit and Loss Participation document
3.    Profit and Loss Participation Documents Convertible to Securities
4.    Bank Bonds and Bank Guaranteed Bonds
5.    Financial Bonds  
6.    Asset Guaranteed Securities 
7.    Covered Bonds
8.    Asset Backed Securities
9.    Shareholder Warrants
10.    Intermediary Institutions Warrants
11.    Sukuk 
12.    Real Estate certificates
13.    Investment Fund Participation Documents 
14.    Future and Option Agreements
15.    Precious Metal Bonds (Gold, Silver, Platin Bonds) 


Although their restrictions do vary from country to country the debt instruments can be issued by governments, local authorities, public businesses, corporates, financial institutions. When the saving volume accumulated in the local capital markets, is not in a position to meet the demand for fund in the market and/or the interest rates in the local markets differ from the interest rates prevailing in the international markets, those who want to benefit from the lower interest rates in foreign markets and those in need of funding, can issue debt instruments, primarily foreign currency bonds, in foreign markets.

According to the JCR ER rating methodology, the rating of debt instruments is based on the credit rating of the issuing institution, and depending on the characteristics of the debt instrument and it can sometimes be above or below the rating of the issuing institution. The debt securities guaranteed by an institution with a higher rating or any asset backed  debt instruments or income flow backed debt instruments issued can have a higher rating than the issuing institution’s rating.   

The rating of Capital Market debt instruments is an opinion on the probability of timely and full payment of the principal and interest of the security in question. In this respect, naturally, the solvency of the security depends on the opinion of the default probability of the issuer company. Even though the issue ratings given by JCR ER in this regard indicate the default risk, they are not an absolute default risk criterion, they are only a comparison of different debt instruments in standard risk categories with respect to each other.

While examining the default risk of capital market debt instruments, factors that will affect the default probability and loss amounts at the time of default are taken into account.

For the probability of default, inferences made from historical default data are taken into account. Loss at the time of default, on the other hand, is basically a function of the amount of use at the time of default, but also depends on many different qualitative factors such as the legal regulations of the countries, investor rights, follow-up systems, enforcement-bankruptcy laws, assets under guarantee of debt instruments.

The loss at the moment of default or the rate of recovery are being impacted heavily by the factor and the most important being the guarantee of the debt instruments. Securitization is the backing of the issued debt instruments with another asset against the risk of non-payment. Guarantees can be very diverse.

•    Asset or income flow backed  
•    Insurance 
•    Guarantee                                                                                                                                      
The quality and liquidity of the collateral is highly influential on the credit risk of the debt securities. Because a strong and liquid collateralization means a strong recovery in case of a default, it raises the rating of the bond. The asset backed bonds issued are considered fully guaranteed. On top of that, capital market debt instruments can be backed by insurance guarantee. Among the aims of insuring;

•    To reach additional investor groups,  
•    To use the price advantage existing in other markets, 
•    To mitigate the transfer and convertibility risk of debt instruments or, in other words, to eliminate systemic risk arising from country risk, 
•    To emphasize the issuer’s specific risk assessment,
•    To accelerate the rating level of debt instruments upwards                                                             
are among the motivations behind. In a broader context, debt instruments are insured by "monoline" bond insurance companies in structured finance bonds. 


The monoline insurance companies are insuring the asset backed bonds issued by issuers from emerging countries, they also insure the securities named sub-prime bonds in developed markets, that is, below threshold or speculative level bonds.

Another way for the issued bond to have a higher rating than the issuer’s rating is to guarantee bonds. The guarantee can be given by another company of the group in which the company issuing the bond is a member, the holding, the shareholder himself or an international organization.                               
The analysis quality of the debt instruments made by JCR ER;

•    The issuer company’s revenues and their sufficiency to repay the capital and interest must be studied,
•    The company’s past and current financial ratios,
•    Whether the debt instruments are secured or not,
•    The adequacy and time coordination of the market values of the assets shown as guarantee and the cash flows to be generated,
•    The protectiveness of the investors, their rights and the law and regulations,
•    The priority status of debt instruments,
•    The issued debt instruments’ maturity (since those with longer term have a lower rating), 
•    The sector’s situation in which the company operates, 
•    The structural strength of the company, financial structure and overall structural strength, 
•    Whether the debt instruments are marketable,
•    The general market interest rates, inflation levels, whether debt instrument’s interest rate fixed or floating or indexed                                                                                                                               
are issues being concentrated on. In general, those who invest in debt instruments are not shareholders of the issuing institution, but the creditors. Although they can’t participate to the management of the institution issuing, the owners of the securities are being paid for the interest before the dividends are paid to the shareholders. From the debt securities perspective the same priority is valid in case of company liquidation. The bonds issuance price and coupon values are being determined according to several criteria. Those criteria are;

•    The credit risk of the issuer (this is being measured by the credit rating of the company),
•    Tax ratio and amount,
•    The maturity of the debt instrument,
•    The liquidity of the other bonds of the issuer,
•    The return of the debt instrument,
•    The margin between the US Treasury Bonds which are being considered as risk free bonds(risk premium),
•    Encompassed by the risk premium are the probability of default of the governments, the loss of value of a country’s money (devaluation) and law and regulation,  
•    The difference between the local capital market regulation and the internationally accepted norms.


In addition to the default risk, there is also the risk of transfer and convertibility in the foreign currency bonds issued by the governments of developing countries in foreign markets. Those type of risks define the risk of governments who might bring restrictions to foreign currency and the probability of their asset in foreign currency being not sufficient to cover their liabilities in foreign currency. The risks entailed by corporate bonds differ according to the economy they operate in. In American corporate bonds only corporate specific risks are in question whereas for emerging market corporates the bonds they issue encompass the systemic risk named country risk and the corporate risk specific. While there is only company-specific risk in American corporate bonds, there are also systemic risk, called country risk, as well as company-specific risks in bonds issued by developing country companies. For those investing in the debt instruments the risks of the debt instruments; 

•    The systemic risk of the issued debt instruments arising from country’s macroeconomic and political environment and the law and regulation,

•    The part of the risk not related with the return of the asset endured by the corporate and the investment and the correlation between market movements is Specific risk,   
•    Transfer and convertibility risk specific to bonds issued in foreign currencies in foreign markets
are constituted by three categories as mentioned.


Systemic risk is the change of market factors such as interest rates, exchange rates, inflation rates, purchasing power changes, which affect all firms, states and projects at different scales, and political crises, wars, international political and commercial disputes, military coups or their possibilities, election periods, the net loss or decrease in asset value due to cash flow disruptions that will be affected by political risk, such as the cessation or reduction of trade relations with neighboring countries. As it is known, purchasing power risk refers to the inflation risk, that is, the gradual loss of the purchasing power of the local currency due to the rise in the general level of prices. For investors, debt instruments issued in local currency mean that their investments lose value depending on the inflation rate. Interest rate risk, on the other hand, is a situation where there is a possibility of up or down volatility in market interest rates, and it is a risk that mostly affects fixed income instruments.

The specific risk is the sum of the specific risks that the company is exposed to in addition to the systemic risk elements contained in government bonds in the debt instruments issued by the companies. The specific risks associated with bonds, are the financial risks defining the financial strength of the company. This risk is associated with the probability of default risk. It can be listed as the risks related to the business line and industry in which the company is involved, and management risk. The time to maturity of the bond and the volatility of the company value of the issuer are also associated with the bond risk and are effective in determining the risk premium of the bond. Risks that companies are exposed to in relation to their operations can be listed as;

•    Project risk, 
•    Competition environment,
•    Industrial Risk,
•    International Risk.


Project Risk: The risks affecting the project. It results in the realization level of the expected and planned cash flows differing from the estimated ones.                                                                        
Competition Environment Risk: These are the risks of positive or negative impact on the cash flow of the project in line with the different movements of the competitors between the realized and expected reactions.                                                                                                                                         

Industrial Risk: Technological risk arising from technology that is realized differently or is renewed than expected, legal risk arising from changes in legal regulations, commodity risk arising from price changes in input goods and services produced by a particular industry disproportionately arise when these three components affect cash flow and earnings of the company.


International Risk: It is the risk that the company will face with respect to its overseas projects, because the currency in which the cash flow of the project is measured is different from the currency in which the company's stock price or earnings are measured. In such a case, the income and cash flow to be generated from the project may be different from the expected due to political risk and changes in exchange rates. These are the additional uncertainties that will occur on the cash flow of the project due to the political risks and currency risks that may occur in foreign markets. 
The ratings given to the company's bond generally reflect the company's creditworthiness in line with financial ratios that measure the company's capacity to meet its debt obligations and generate a stable cash flow.

As a result, in the JCR ER methodology, the Corporate Credit rating of firms, central governments, local administrations, public enterprises, financial institutions and similar issuers is taken as the basis for the rating of debt instruments. Corporate Credit ratings already include the specific, systemic, transfer and convertibility risks listed above. Therefore, on top of the corporate credit rating, the debt instruments;

•    Guarantee structure,  
•    Whether it is insured or not, 
•    Whether it is covered by the guarantee or not, 
•    Maturity, 
•    The level of protection of the investors                                                                                           
being evaluated separately, the results being calculated from these factors are being added to the corporate credit risk and form a new independent rating for the debt instruments. If there has not been established a guarantee structure for the debt securities, the credit rating and the issuance rating are formed at similar levels.