Does your exam grade affect how your teacher writes about you in the report card? Does the tone your teacher writes about you affect your future performance? It seems so when it comes to sovereign credit rating. Accurate assessments of sovereign default risk are economically important as highlighted by the recent Eurozone sovereign debt crisis. Not only do these reports communicate opinions of creditworthiness of countries, they also furnish qualitative information for justifying rating action decisions. They are important because the economic consequences of credit rating actions can be huge as they can affect the efficiency and stability of capital markets within and across countries. One such assessment comes from credit rating agencies (CRA) who issue sovereign credit rating reports. However, the quality of these reports is sometimes questioned.

Unlike corporate credit ratings or stock analyst reports, a significant number of these sovereign credit ratings are unsolicited. As an industry practice, CRAs provide such reports during credit rating action announcements and do not charge any additional fees for the production and dissemination of the reports. Without access to insider information or direct monetary compensation from their rating agencies, are CRAs properly incentivized to furnish valuable information on the sovereign credit ratings as they do on corporate credit ratings? We analysed the text of sovereign credit rating reports published by Moody’s for more than 70 countries from 2003 to 2013and classified every sentence in each report into two linguistic tone categories - positive

or negative. We find that reports with a negative linguistic tone contain new defaulted-related information beyond credit rating changes. Lower initial ratings, lower GDP growth, lower debt-to-GDP ratio, lower ratio of foreign reserves to GDP, and lower ratio of trade balance to GDP are related to a negative tone, and vice versa for a positive tone in these reports.

Lower initial ratings, lower GDP growth, lower debt-to-GDP ratio, lower ratio of foreign reserves to GDP, and lower ratio of trade balance to GDP are related to a negative tone, and vice versa for a positive tone in these reports

Additionally, investors put more importance to negatively-toned information than positively worded ones. Why? As a downgrade is a more severe event than an upgrade, CRAs are more cautious in providing additional information to justify their downgrade decisions. As such, tones in downgrade reports are seen as having more information value than upgrade reports. We also assessed whether the tone furnishes value-added information – do investors see the information as different from and beyond that offered by other contemporaneous credit rating actions such as watchlist and outlook actions? Indeed, they do. Investors find that the tone provides information value about default risk beyond that by watchlist and outlook actions, and augments these credit rating actions. Interestingly, negatively-toned reports are predictors of future rating downgrades. When a more negative tone is used, the probability of future downgrades is higher, even when there are other rating actions such as watchlist and outlook actions present. Hence, beyond mere prediction, tone adds incremental value to the prediction on top of other rating actions.

We then identify the most valuable information content in the rating reports by classifying each sentence into six content categories - macroeconomic, public and external finance, debt dynamics, financial sector, political and institutional, or others. We find that negative-toned sentences associated with debt dynamics are given more importance by investors than the other content categories. Such negative-toned information related to financial sector content in sovereign credit rating reports also become less informative over time, particularly after the Eurozone debt crisis. This may be due to a loss of confidence and trust among investors on the financial risk assessment in credit rating reports. This study has both practical and policy implications. First, investors can employ sovereign credit rating reports as an additional source of information to assess default risk of the country. Second, regulators and policymakers need to improve regulation on the format and content of sovereign credit ratings to provide better and more reliable information to investors.