What's the trouble with a lower bond rating?

S&P announced that it downgraded the U.S. debt from AAA to AA+ Friday night. Commentators are split as to whether this would have major negative consequences for both the U.S. and world economy, or whether it would be basically meaningless.

Why it might matter

If the U.S. debt gets downgraded, many other debt instruments will likely get downgraded as well. When Moody's put U.S. debt on review for downgrade during the debt ceiling standoff, if also put on notice 7,000 other bonds, worth a total of $130 billion, that rely directly on revenue from federal government payments, such as certain kinds of municipal bonds. Bonds that are indirectly dependent on the federal government, such as those issued by hospitals that receive Medicare payments, or defense firms reliant on Pentagon contracts, could get downgraded as well. In addition, many everyday interest rates — such as those for mortgages, car loans and credit cards — are pegged to U.S. Treasuries, meaning that if a downgrade forces up interest rates on U.S. debt (which is likely, but will depend on how the markets react) interest rates for those will shoot up as well. This would raise the cost of borrowing across the system, depressing the economy.

It would also lead to widespread uncertainty. As the Post's Ezra Klein has written, "The cornerstone of the global financial economy is the idea that Treasuries are risk-free." A downgrade would mean Treasuries are no longer risk-free, and thus shake up the whole system. The last time AAA debt lost its luster in such a dramatic fashion was 2008, when AAA-rated subprime securities were discovered not to be sound. The result was the current financial crisis.

Additionally, many institutional investors — such as pension or money market funds — are required to hold a certain amount of AAA debt, meaning that some might be forced to sell off U.S. debt in the event of a downgrade. Given that money market funds hold about $338 billion in U.S. debt, or almost half of short-term holdings, this would be an enormous sell-off, which would raise interest rates still higher and greatly amplify the economic damage incurred due to a downgrade.

Why it might not

Ratings are generally used as a proxy to determine the financial health of entities that investors may not know much about. But everyone knows about the health of the U.S. government, and now that the debt ceiling debate has passed no one thinks it is going to default any time soon. Thus, investors that might normally be inclined to not buy or keep AA rated debt could make an exception for U.S. Treasuries. Indeed, some pension and money market funds have considered loosening their rules around debt ratings to allow higher holdings of U.S. debt in the event of a downgrade. Further, AA is still a very high rating. AA firms have statistically identical performance to AAA ones, according to the Fitch rating agency. Just this past January, S&P downgraded Japan's debt from AA- to AA, and markets more or less didn't care.

Bottom line

The United States has never been in this situation before, so it is hard to see who is correct. When, in April, S&P declared the long-term outlook on U.S. debt to be negative, it was the first time it had done so since Pearl Harbor. Moody's has rated U.S. debt as AAA since the firm started conducting ratings in 1917. There is simply no modern precedent for a U.S. downgrade.

The Triple A Club:

risk-free borrowers

These 18 countries have the highest credit rating, AAA, from Standard & Poor's. The triple-A rating enables nations to borrow funds at a low cost, because their governments are considered stable and their bonds safe. Moody's and Fitch are the other two agencies that grade the credit of companies and governments.

Australia

Austria

Canada

Denmark

Finland

France

Germany

Guernsey

Hong Kong

Isle of Man

Liechtenstein

Luxembourg

Netherlands

Norway

Singapore

Sweden

Switzerland

United

Kingdom

Source: Standard & Poor's; CNN

What's the trouble with a lower bond rating? 08/06/11 [Last modified: Saturday, August 6, 2011 12:11am]

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