Will US debt rating be downgraded again?

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With politicians in Washington still wrangling over possible solutions for averting the so-called “fiscal cliff” in the last few days before year-end, the major credit rating agencies may be loading their guns to take another shot at downgrading America’s debt.

In a shocking move last August, the Standard and Poor’s bond rating agency re-rated US government debt down to AA+ from AAA, reducing the country’s vaunted credit score for the first time in 70 years. However, the other prominent rating services, Moody’s Investor Service and Fitch who have so far stayed with their AAA blessing are but are preparing to drop their ratings if the country cannot get its act together soon.

Until last year’s downgrade, few would have imagined that the credit rating on US government debt would ever fall below the highest level of AAA. After all, the United States is the world’s largest economy and US Treasury securities are widely considered to be the gold standard for measuring credit quality. In fact, almost all other US dollar-denominated fixed income securities are priced and traded directly in relationship to comparable Treasury bills, bonds and notes.

The amount of outstanding US government debt is massive. US Treasury securities represent the largest percentage of the broad-market bond indices which are market-weighted, or constructed according to the relative size of the sectors. For example, the widely followed Barclays US Aggregate Bond Index is comprised of a 36 percent weighting in Treasury securities.

In addition to the publically-traded bond markets, many private loans to creditors are secured by US government securities, universally considered to have the least chance of defaulting amongst all of the bond sectors. According to a column published in the Wall Street Journal, “JP Morgan Chase & Co analysts estimate some $4 trillion worth of Treasuries are pledged as collateral by borrowers such as banks and derivatives traders. If that collateral isn’t considered as high quality by lenders, the borrowers could be required to cough up more cash or securities to put the minds of lenders at ease.”

So what happens when the world’s largest bond sector faces a potential downgrade due to political instability, runaway budget deficits and an anaemic economic recovery?

The answer might be found in what was witnessed last year at the time of the S&P downgrade, which also involved longer term US securities being placed on “negative watch”. S&P said they believed “the fiscal consolidation plan that Congress and the Administration recently agreed fell short of what is necessary to stabilise the government’s medium term debt dynamics”. The downgrade was prompted by the debt ceiling debate which requires Congress to approve increases in America’s debt capacity at regular intervals.

S&P argued that the predictability and effectiveness of American policymaking had both declined to a level of concern and cited pessimism that Congress and the Administration could bridge the vast gulf between the two main political parties. In short, the agency took a “show me” attitude about America being able to hammer out an effective plan which put the country back on track.

Oddly enough, Treasury bond prices had actually been increasing in the midst of the debt ceiling debate in the summer of 2011 as investors grew sanguine about the prospects for a successful budget negotiation. Prices rose and yields fell right up until the day of the downgrade after which bonds sold off sharply. On that day, the benchmark ten-year US Treasury bond yield ticked up to from 2.47 percent to 2.58 percent and prices of bonds declined across the curve.

Immediately after the S&P downgrade, however, investors shrugged off the news and Treasury bonds resumed their rally into the end of the year. Perhaps bond buyers were encouraged that an agreement had finally been struck and that Moody’s and Fitch, the two other major credit rating agencies had not followed the S&P action. Massive bond buying the US Federal Reserve didn’t hurt either.

What happens to bond yields and prices now depends largely upon how quickly American politicians can come to an agreement and how the rating agencies interpret the news. For example, following last year’s downgrade, S&P stated that they would consider another reduction in the credit rating grade “within the next two years if (the S&P rating agency) sees less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period.”

Meanwhile, Moody’s Investor Service, has lately voiced escalating concern with an emphasis on the political dysfunction in Washington. The agency stated the government must come to agreement to head off billions of dollars in simultaneous tax increases and spending cuts scheduled to begin in January and to put the government on a sustainable fiscal trajectory. Only then would the United States keep its AAA rating.

The third major credit rating agency, Fitch warned earlier this month that political inaction could result in a credit downgrading. “If the negotiations on the fiscal cliff and raising the debt ceiling extend into 2013 and appear likely to be prolonged with adverse implications for the economy and financial stability, the US sovereign rating could be subject to review, potentially leading to a negative rating action.”

US Treasury securities, once considered the hallmark of credit quality are now standing in the cross hairs of all three major credit rating agencies and are in line for further negative action. Prices have been pressured in recent weeks as a result of the sloppy negotiations and also in reaction to a surprisingly resilient economy which may be showing early signs of inflationary pressures.

For better or worse, Treasury bond ratings, prices and yields are now largely in the hands of politicians and their actions (or inaction) in the weeks and months ahead. While we are guardedly optimistic that a sensible deal will ultimately be hammered out in Washington, clearly some damage has already been done.

At this juncture, it looks like the details for a cliff avoidance agreement could drag on into the new year with tax changes being made retroactive. In the meantime, the credit agencies are poised to take further actions, or at least continue to issue warning statements likely to make credit markets bumpy in the weeks ahead.

Bryan Dooley, CFA is a senior portfolio and fund manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service.

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Published Dec 29, 2012 at 8:00 am (Updated Dec 28, 2012 at 5:40 pm)

Will US debt rating be downgraded again?

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