The logic of the ‘sovereign ceiling’

The sovereign ceiling essentially refers to the credit rating of corporate bonds being constrained in some way by the credit rating of the country of the bond-issuing company. There is some good logic behind this policy on the part of international credit rating agencies. 

First, companies and governments operate within the same environment. A country-level economic downturn can impact the financial health and prospects of domestic businesses. 

Second, there’s a potential legal and regulatory linkage, as sovereign governments have the power to directly affect companies within their jurisdictions. For example, by changing tax policies or imposing new regulations.

In some cases, government can take more extreme measures, such as revoking licenses to operate, imposing currency exchange controls, or, in rare occasions, seizing corporate assets. This category is often referred to as ‘transfer risk’ – the possibility that a country’s financial problems could be passed on to the companies operating within its borders.

Potential ceiling issues

While the sovereign ceiling has some intuitive merit, it also presents challenges. 

The idea that company credit ratings must be constrained by country ratings has become less persuasive over the years. In today’s globalised economy, many businesses operate across multiple jurisdictions, making country-level limitations less relevant. 

Meanwhile, EM corporate governance and credit fundamentals have improved significantly. This is reflected in the better ratings of EM corporates. In 2024, EM corporate bonds recorded their biggest positive net credit rating since 2012, with upgrades surpassing downgrades by net USD 70 billion, or 2.8% of total EM corporate bonds outstanding [1]. 

Another indicator of this trend is the composition of the JP Morgan Corporate Emerging Markets Bond Index. Bonds rated A and above now account for 37% of the Index, compared to an average of 32% over the last five years [2]. 

Investment implications

With EM corporate fundamentals generally improving and ratings moving higher over time, this has tended to increase instances where the sovereign rating ceiling becomes a relevant constraint. In such cases, a ratings mismatch relative to actual corporate fundamentals can be a source of market inefficiency that skilled active bond managers can potentially take advantage of.

Case study – Turkcell v Vodafone

To illustrate the impact of the sovereign ceiling, consider two leading telecoms companies: Turkcell, the largest mobile operator in Turkey, and Vodafone, the market leader in the UK. 

Turkcell has better fundamentals than Vodafone, including a higher domestic market share, superior profit margin (earnings before interest, taxes, depreciation, and amortisation) and significantly lower net leverage. Despite this, its bonds trade at a notable discount. Both its gross yield and z-spread (the excess yield over US Treasuries) are more than two percentage points higher than those of Vodafone.

Turkcell/Vodaphone ratings and fundamentals

Source: Company websites, Bloomberg, May 2025.

What explains this apparent anomaly? As ever, it would be an oversimplification to point to a single factor. In this case, though, it appears Turkcell’s sub-investment-grade BB- credit rating – four notches below Vodafone’s investment-grade BBB rating – is at least partly constrained by Turkey’s B+ sovereign rating. 

To be clear, this doesn’t mean Turkcell’s corporate bonds are necessarily cheap or attractive. The key question for investors is whether Turkcell’s 230 basis point excess spread over Vodafone adequately compensates for all its relative disadvantages, including risks associated with operating in a lower-rated country. 

This type of analysis requires the ability to assess both sovereign risks and corporate credit fundamentals.

Final thoughts…

The sovereign ceiling limitation placed on the credit ratings of EM corporate bonds has some valid underlying logic. However, over time the rationale has been weakening. This is owing to EM companies becoming more globalised, as well as structurally improving credit fundamentals reflected in ratings progression. 

As a result, more EM companies are either approaching or already constrained by sovereign ceilings. This creates a potential source of market inefficiency — one that a skilled investor, capable of assessing both corporate and sovereign risk, can look to capture.