Credit Analysis for Government Issuers: formula sheet

Key formulas

Two-part test of sovereign credit risk

Sovereign credit assessment considers both ability to pay and willingness to pay.

This is a framework, not an equation. Weakness in either part raises risk. Low risk needs a strong economy and fiscal position and a record of honoring debt.

Currency rating rule

Local currency rating ≥ foreign currency rating (typically)

Typical, not guaranteed. The gap shrinks when the country has flexible, credible monetary policy and large foreign reserves, or when the currency is not its own.

Debt burden ratio

Government debt-to-GDP = government debt ÷ GDP

Higher ratio means a heavier burden and weaker ability to pay, all else equal.

Debt burden ratio

Debt burden = Government debt ÷ GDP

Higher is weaker, but compare with growth, interest cost and currency of debt. There is no single safe threshold.

Interest burden

Interest burden = Interest payments ÷ Government revenue

Shows how much revenue is absorbed by debt service. Higher means less fiscal room.

Six determinants

Institutions + Economy + Fiscal flexibility + External position + Monetary flexibility + Debt burden

Use as a checklist to classify any scenario clue.

Currency rule

Local-currency debt risk < Foreign-currency debt risk (generally)

A government can print its own currency but not foreign currency; the trade-off is inflation.

Recovery rate and loss severity

Loss severity = 1 − Recovery rate

Recovery rate is the share of claim value recovered. A 40% recovery means a 60% loss.

Haircut

Haircut = 1 − (PV of new package ÷ face value of old claim)

Creditors measure losses by the value of what they receive, not just the nominal face value.

Expected loss

Expected loss = Probability of default × Loss severity

Applies to sovereigns as to corporates, but sovereign recovery has no fixed priority rule.

Collective action clause

Qualified majority of holders agrees → terms bind all holders of the bond

The exact threshold is set in the bond contract. Do not assume a fixed percentage.

Debt service coverage ratio (revenue bonds)

DSCR = Net revenue available for debt service ÷ Debt service

Higher is safer. A DSCR below 1.0 means revenue does not cover debt payments. Rate covenants often require a minimum above 1.0.

Debt burden measures (GO bonds)

Net debt per capita = Net debt ÷ Population; Debt ratio = Net debt ÷ Taxable property value (or income)

Used to compare issuers. Lower is generally stronger. Include pensions and other long-term obligations when told to.

GO versus revenue backing

GO = taxing power of issuer; Revenue = cash flow of the specific project

This is the core rule for classifying and ranking the risk of the bond.

Quick revision

• Sovereign debt is not risk free; credit risk depends on ability and willingness to pay.
• Willingness to pay is hard to enforce because creditors have limited legal recourse against a sovereign.
• Local-currency debt is usually rated higher than or equal to foreign-currency debt, because the government can create its own currency.
• Foreign-currency debt needs foreign exchange the government cannot print.
• Determinants group into institutions, economy, fiscal strength, monetary flexibility and external position.
• Strong institutions and predictable policy support creditworthiness.
• High debt burden, weak growth and large deficits weaken fiscal strength.
• A country with a credible central bank and flexible exchange rate has more monetary flexibility.
• External weakness shows up as reliance on foreign funding and low reserves.
• Default and restructuring outcomes vary; creditors often accept lower value, longer maturities or both.
• Non-sovereign issuers rely on their own taxes, fees or project revenue and may receive higher-government support.
• Ratings are opinions on relative risk, not guarantees of default or survival.

Common mistakes

• Treating ability and willingness to pay as the same thing. Fix: Ability is about capacity (economy, finances). Willingness is about intent (politics, institutions, past behavior). A rich country can still be a poor payer.
• Assuming foreign currency ratings are higher than local currency ratings. Fix: A government cannot print foreign currency, so foreign currency debt is usually rated the same or lower than local currency debt.
• Treating sovereign default as only an ability-to-pay issue Fix: Always consider willingness too. Weak institutions or political instability can cause default even with adequate resources.
• Assuming high debt to GDP alone means low creditworthiness Fix: Judge debt with growth, interest cost, currency, maturity and fiscal flexibility. A country with deep local markets and its own currency can carry more debt.
• Treating sovereign default like corporate bankruptcy with court-set priority. Fix: Remember there is no global bankruptcy court. Outcomes come from negotiation.
• Assuming a CAC binds all creditors on all bonds. Fix: A CAC binds holders of the bonds covered by its terms, by the specified majority. Aggregated clauses can span series, but check the wording.
• Treating revenue bonds as backed by the issuer's taxing power. Fix: Revenue bonds look only to the project's revenue unless the terms say otherwise. Always ask who pays.
• Assuming GO bonds are always safer than revenue bonds. Fix: Compare the actual credit factors. A strong essential-service revenue bond can be safer than a GO bond from a heavily indebted issuer.

Exam tips

• Sort every stem clue into ability or willingness first. That alone removes one wrong option in many questions.
• Expect the local versus foreign currency comparison. Remember local is usually equal or higher.
• Watch for absolute words like 'always' and 'never'. Sovereign credit rules are tendencies.
• Link this topic to the determinants of sovereign creditworthiness and to sovereign default and restructuring, since questions often blend them.
• With no penalty for wrong answers, never leave a question blank. Eliminate one option and guess between the other two.
• Match the keyword to the factor first, then judge direction. Most questions are that simple.
• Remember local-currency versus foreign-currency debt. It is a favourite trap.
• Questions may say a debt ratio is high; check the options for growth or currency offsets before deciding.