Standard & Poor's decision on April 18, 2011, to place the United States' credit rating on negative outlook served as a shot across the bow for both U.S. policymakers and investors around the globe. The rating agency assigned a one-in-three probability that the U.S. will lose its pristine "AAA" credit rating, perhaps in the next 18 to 24 months. At this point, the prospects for a political compromise that would place the country on a path toward fiscal sustainability and forestall a downgrade appear bleak. Republicans are insistent that the deficit must be narrowed without any tax increases, while Democrats are adamant about not cutting entitlement spending.
Despite the seeming intractability of the two sides' respective positions, investors would do well to remember that, as Winston Churchill famously said, "Americans can always be counted on to do the right thing ... after they have exhausted all other possibilities." In other words, despite how poor the odds of compromise currently appear, there is still a very good chance that policymakers will eventually find a solution that will allow the U.S. to retain its "AAA" rating. In fact, S&P actually affirmed the country's current "AAA" rating, as did Moody's.
On the other hand, if the U.S. does indeed suffer a ratings downgrade, the event would undoubtedly prove bruising to the psyche of a nation still reeling from the effects of the financial crisis and Great Recession. Furthermore, a downgrade would trigger an avalanche of negative commentary from market participants, politicians and media pundits. All of this chatter will simply be background noise though, because, as this article will demonstrate, a U.S. credit downgrade will ultimately have little real impact on investors.
Are U.S. Treasurys Junk?
A credit rating is ultimately an indication of the likelihood that bondholders will receive full and timely payment of all principal and interest. A higher rating indicates greater certainty of repayment, and a lower rating less certainty. However, even if the United States is downgraded, this will not materially impact the country's ability to repay its debt. As the world's reserve currency, the U.S. issues debt denominated in dollars, which means that in a worst-case scenario the government could simply print more money to pay back bondholders. Although this is an extremely unattractive option, it is unlikely that the U.S. reaches a point where it even needs to consider rolling the printing presses.
First of all, even in the event of a downgrade the United States would likely carry a "AA" credit rating-one of the highest available and still indicative of exceptional creditworthiness. Second of all, the United States remains the world's largest economy, and has one of the world's highest standards of living, a well-educated population, reasonably good demographics, and a well-established legal and political system. Additionally, if investors are to forsake the U.S., they need a viable investment alternative. With Europe and Japan facing their own issues and the developing markets still, well, developing, the U.S. is likely to remain the world's premier investment destination. Despite what doom-and-gloom pundits might say, this situation is unlikely to change in the decades to come.
Finally, counterintuitive as it might seem, a credit downgrade might actually help the United States. Ultimately, what matters is not the relative credit rating assigned by rating agencies but rather the country's ability to pay back its debt. Regardless of any ratings action taken, the United States is currently on an unsustainable fiscal path. If a downgrade can help spur more timely action on some of the structural problems the country faces, such an event might actually prove beneficial in the long run.
Bill Gross Is Selling-Should You?
With all of the bad news about the Treasury market, many investors have recently been asking themselves if they should follow Bill Gross (of bond giant Pimco) and sell all of their U.S. Treasurys. Before doing so, it might be wise to consider several points. First of all, Bill Gross could very well be wrong about Treasurys. After all, while he has an outstanding track record and is extremely intelligent, even the best investors can't always be right and many other large investors (such as Jeffrey Gundlach, who CNBC recently called the best bond manager of the past decade) are on record disagreeing with Gross' position. And in fact, ten-year Treasury yields have fallen by around 40 basis points in the past six weeks.
More important, many of the Pimco portfolios that sold Treasurys have an exceptionally wide mandate and can invest in nearly any fixed-income asset class around the globe. Most investors are more constrained and are limited by their investment mandate-they can only purchase domestic fixed income, for instance, or only bonds rated "A" or better.
Furthermore, many institutions have structural reasons for purchasing Treasurys; for example, bank capital requirements encourage holding a certain percentage of Treasurys. This preference for holding "safe" assets has only been reinforced by the ongoing efforts at financial reform. These structural considerations greatly restrict the available investment choices for many investors while also ensuring that there will continue to be a built-in investor base that purchases Treasurys.
In the end, an average high-quality fixed-income investor's options are primarily limited to government bonds, government agency bonds, high-grade corporate bonds, and mortgage and asset-backed securities. For most of these investors, U.S. Treasury bonds will remain the safest possible investment alternative, regardless of what credit rating the U.S. carries. Moreover, in the event that Treasurys are downgraded, many other instruments that receive implied or explicit rating support from the U.S. government might also be downgraded, including government agency bonds, mortgage-backed securities and perhaps the bonds of large banks, whose ratings are currently enhanced by implied government support.
Finally, regardless of any ratings actions, the Treasury market will likely remain the most liquid fixed-income market in the world. This liquidity is one of the primary reasons that foreign investors such as the Chinese government purchase Treasurys in the first place. Simply stated, not many other markets around the globe are capable of absorbing the huge amounts of money seeking a high-quality, low-risk outlet.
This liquidity component is often demonstrated during times of market crisis when investors generally bid up the price of Treasurys in a flight to quality. The dual characteristics of safety and liquidity are somewhat unique to Treasurys and represent a compelling argument for why they will continue to form an important component of many investment portfolios.
Tactics Versus Strategy
Speculation about a U.S. downgrade or its actual occurrence will likely have an impact on Treasury trading over a period of days or perhaps even weeks. However, in the longer term this impact will be outweighed by market-moving events such as the economic cycle; the level of inflation and inflation expectations; and Federal Reserve monetary policy. The price of Treasurys will rise and fall across market cycles just as they always have, but any repricing that results from a credit downgrade is likely to be both minimal and transitory.
Savvy investors might try to time the market, and selling Treasurys at this point could be the right thing tactically (during the current market cycle) while still being incorrect strategically (over the life of your investment program). Of course, selling Treasurys now requires the impeccable timing needed to repurchase them at precisely the right moment; some investors may be fortunate enough to have this timing, but it is a rare skill and the opportunity cost is high for those that get it wrong. For that reason, most investors are well advised to maintain their strategic allocation to U.S. Treasurys rather than abandoning them as part of a tactical market call.
Conclusion
A U.S. credit rating downgrade would undoubtedly hurt the nation's pride while unleashing a torrent of negative publicity both domestically and abroad. Nevertheless, the real impact on investors would most likely be decidedly muted, particularly in the longer run. Treasury securities have a built-in investor base that has few investable alternatives, and those that do exist would likely be downgraded in line with Treasurys. Furthermore, even with a "AA" credit rating, U.S. Treasurys would remain among the safest, most liquid securities in the investment world.
In the long run, it is possible that interest rates on Treasurys may rise, but this is far more likely to occur due to stronger economic growth or tighter monetary policy than as a result of any ratings actions S&P or Moody's might take. Regardless of headlines, Treasurys are set to remain the foundation of investment-grade fixed-income portfolios for decades to come.
Brian Perry is portfolio manager/strategist at Chandler Asset Management and the author of From Piggybank to Portfolio: A Financial Roadmap for New Investors.