Impairment of Sovereign-Debt Investments: As Governments throughout the World Become Less Creditworthy, Holders of Sovereign-Debt Securities May Need to Reexamine Their Financial Reporting

By Pounder, Bruce | Strategic Finance, February 2012 | Go to article overview

Impairment of Sovereign-Debt Investments: As Governments throughout the World Become Less Creditworthy, Holders of Sovereign-Debt Securities May Need to Reexamine Their Financial Reporting


Pounder, Bruce, Strategic Finance


National and local governments frequently borrow cash by issuing debt securities (e.g., U.S. Treasury bonds). Such sovereign-debt securities are widely held as investments by many kinds of entities, especially financial institutions and insurance companies. In this month's column, I'll discuss how recent declines in the creditworthiness of many countries have given rise to financial-reporting implications for investors in sovereign-debt securities.

Background

Although sovereign-debt securities typically are backed by the "full faith and credit" of the governments that issue them, entities that invest in such securities still bear some credit risk--that is, the risk that debtor governments won't pay principal and interest in full and on time. Naturally, the credit risk associated with a specific sovereign-debt security reflects the creditworthiness of the issuing government, which can change over time. Because an accurate, current assessment of sovereign credit risk is important to both debtor governments and investors, credit-rating agencies (CRAs) routinely assess the credit risk of sovereign-debt securities. The most active and influential CRAs are Standard & Poor's, Moody's, and Fitch.

Greece has emerged as the most prominent recent example of sovereign credit risk. Like most countries, Greece has issued sovereign-debt securities, which generally are referred to as Greek government bonds (GGBs). By mid-2011, CRAs had significantly downgraded GGBs well into "junk" territory as the risk of Greece's default on those obligations grew. Market prices of GGBs hit historical lows, and the cost of buying credit protection against GGB default (e.g., via credit-default swaps) hit historical highs. At that point, creditors weren't concerned with whether they would "take a haircut" on GGBs--it was how much.

But Greece isn't the only recent example of the increasing riskiness of holding sovereign-debt securities. On August 5, 2011, Standard & Poor's downgraded the credit rating of the United States's long-term sovereign debt from AAA (the highest rating) to AA+ (the next-highest rating). Interestingly, while market prices of most investment assets declined globally as investors perceived them to be more risky in absolute terms than they had previously thought, market prices of downgraded U.S. sovereign-debt instruments actually rose as investors shifted their asset allocations to investments that were relatively less risky. Investors still widely considered U.S. Treasury securities to be the least risky investment of any kind.

More recently, on January 13, 2012, Standard & Poor's downgraded the sovereign debt of nine eurozone countries. Most notably, France and Austria, which held AAA ratings, were downgraded to AA+ status. Italy and Spain, while significantly downgraded, maintained investment-grade ratings (BBB+ and A, respectively). Faring worst were Portugal and Cyprus, whose sovereign debt was downgraded to junk-grade status (BB and BB+, respectively). Yet market prices for sovereign-debt securities issued by many of the downgraded countries remained relatively stable. This phenomenon likely reflected circumstances in which investors already perceived an accurate level of credit risk before the formal downgrade.

Investors' Financial Reporting

Even though credit-rating downgrades and declines in market prices of sovereign-debt securities have occurred, these events may or may not affect financial reporting by entities that have invested in such securities. Whether an investor entity must alter its reported investment values and/or disclosures depends on which set of financial reporting standards it follows.

In particular, U.S. Generally Accepted Accounting Principles (GAAP) requires each investor entity to periodically assess whether debt securities held as assets, other than securities held for trading purposes, are impaired. Section 320-10-35 (Investments--Debt and Equity Securities > Overall > Subsequent Measurement) of the Financial Accounting Standards Board's (FASB) Accounting Standards [Codification. …

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