America’s Student Loan Crisis Risks Turning AAA Debt Into Junk

It’s no secret Americans are having trouble paying off their record $1.2 trillion in student loans. What’s less known is that the trend is turning a typically sleepy corner of the bond market into a potential hazard zone.

People who borrowed money for education before the financial crisis are taking longer than forecast to repay their debt, thanks in part to relief programs. That’s creating a risk for holders of securities created by bundling the loans -- which are government guaranteed -- because the bonds may not be retired by maturity.

As a result, Moody’s Investors Service and Fitch Ratings are considering cutting their rankings on almost $40 billion of securities, possibly dropping top-rated debt to junk status. The potential downgrades threaten to unleash an unusual situation where fundamentally sound bonds with minuscule coupons that reflect their low default risk would need to find new buyers, potentially crushing their prices.

“If this shows up in the junk category, we’re going to compare it to other below investment-grade investments,” said Jason Callan, head of structured products at Columbia Threadneedle Investments, which oversees about $500 billion in assets. “We’d probably find better value in other alternatives.”

Sapping Demand

Bondholders would be faring better if more Americans were actually defaulting, instead of pushing off paying down their debt through a variety of means, given the government guarantees 97 percent of the balances of these loans. While investors see little risk they won’t eventually get all of their money back, the potential rating cuts still threaten to sap demand.

Credit grades still govern many investors’ decisions and, as a result, analysts from Wells Fargo & Co. to JPMorgan Chase & Co. are warning that forced sales by some bondholders are possible.

A Fitch rating “designates the likelihood of the bond to meet its terms, which in every case includes meeting its final maturity payment,” said Michael Dean, a managing director. “The market is going to react how it is going to react.”

Callan said money managers with ratings-based investment guidelines often don’t have to sell downgraded debt, though they may be restricted from adding to their holdings.

Repayment Plans

A 2008 Sallie Mae bond at risk of downgrade illustrates investors’ dilemma. The deal’s amount of loans in repayment periods -- when borrowers actually face required bills rather than relief granted because of things like being still in school, doing a fellowship or facing temporary economic hardship -- has stalled out at between 60 percent and 70 percent, according to Wells Fargo analysts. Of those, 21 percent were delinquent.