Downgrade Threat
A ratings downgrade remains possible if Washington fails to act but may not necessarily translate into higher interest rates. The major rating agencies have stated that the U.S. sovereign rating may once again be downgraded if political infighting derails efforts to produce more substantial long-term deficit reduction. However, history tells us bond markets have produced only a limited reaction to prior sovereign downgrades on average [Figure 3]. The average yield change has been negligible following downgrades and other factors, such as economic growth or central bank actions, have been focal drivers of interest rates for highly rated countries.
As stated in our Outlook 2013, we expect yields to remain range-bound for much of 2013 and only drift slightly higher. Challenges remain that are likely to limit the potential rise in rates, especially given the Fed’s commitment to refrain from raising interest rates until the unemployment rate drops to 6.5% or lower. Last week’s employment report was encouraging but not strong enough to cause the Fed to remove stimulus or to change market perception that it may take another two years to reach that threshold and a possible first rate increase.
Treasury valuations, as measured by inflation-adjusted yields, improved recently but remain very expensive by historical comparison [Figure 4], so pullbacks on an improved growth outlook or changing Fed view as experienced last week can occur. To guard against this risk, we remain biased toward corporate bonds, both investment-grade and high-yield, as well as municipal bonds—all of which possess better valuations.
Valeri has been with LPL Financial since June 1993. As Senior Vice President and Market Strategist, Anthony is a member of the Research department’s tactical asset allocation committee and is responsible for developing and articulating fixed income and general market strategy. Prior to joining the Research Department in January 2002, Anthony was Head Trader of the LPL Financial fixed income trading desk and has 18 years of investment experience.
