Standard & Poor’s Downgrades U.S. Debt

Wild swings in the U.S. stock market escalated to unprecedented levels last week as the Dow Jones Industrial Average gyrated over 400 points on 4 consecutive trading sessions. Market observers agree that the principal catalyst of this turmoil was the decision by S&P to lower the U.S. Government’s credit rating from AAA to AA+. The downgrade and the market’s reaction raise important questions:

• Was the downgrade warranted?

• Will it have a lasting impact on the U.S. and global financial markets and economies?

The downgrade was promptly supported by some conservative economists even as it was condemned by the White House and prominent financial leaders including Warren Buffett. Stirring the controversy was that neither of the other two rating firms, Moody’s and Fitch, reduced their top ratings. Moody’s sharpened its disagreement with its larger competitor on August 8 by emphasizing on its website its reasons for not reducing its rating (moodys.com).

We accept S&P’s own definition of the proper function of credit ratings; they “express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time” (standardandpoors.com). By this standard, the downgrade is dubious. The U.S. Treasury has affirmed clearly that its highest priority is to stand behind U.S Government debt and, with the raising of the debt ceiling by Congress and the President on August 1, there is no legitimate doubt as to its ability and determination to honor this pledge.

To justify its downgrade, S&P executives asserted that they were influenced by the messy, acrimonious struggle between Republicans, Democrats, and the Administration to reach a compromise. Here S&P is introducing criteria for a downgrade that is outside their own definition of the purpose of credit ratings. Congressional and S.E.C. investigations into S&P’s action have been launched, and in particular they will focus on whether S&P was motivated by a desire to influence politics. It is noteworthy that S&P is already under investigation by aggravated Euro Area governments for using sovereign debt downgrades to improperly impact political processes.

The initial fear of economists, policy makers and investors was that the downgrade would damage the U.S. economy by driving stock prices lower and bond yields higher. This has not happened. Key governments, including China, promptly declared last weekend that the downgrade would not impact their purchase of U.S. Treasurys. When markets opened after the weekend, investors increased their appetite for Treasury securities and drove yields to lows not seen since the crisis days of late 2008. For the week, the yield of benchmark 10-year Treasurys fell from 2.56% to 2.24%, while 2-year Treasurys dropped from 0.29% to 0.18%. Obviously, investors ignored S&P’s warning and, to the contrary, established unmistakably that in their view U.S. government securities remain the safest investment in the world. Last week’s trading also indicates that bond investors are shifting from credit agencies like S&P to credit default swaps (insurance premiums paid in the open marketplace by bond investors in order to protect against default) to determine the relative credit risk of sovereign debt. The role of rating agencies in sovereign debt markets is fading.

Will the downgrade of U.S. debt by S&P continue to roil global stock markets? We do not think so. Following three consecutive up days for U.S. stocks, it appears that the initial dramatic impact of the downgrade is already diminishing. If the bond market continues to ignore the downgrade, the stock market will likely follow. The real threat to the U.S. and global equity markets is an inability of U.S. policy makers to take decisive action on the issues of deficit reduction and job creation.

We think that S&P has acted unnecessarily and, given the fragility of the stock market and economy, irresponsibly. Fortunately, we do not think the downgrade will have a lasting impact.

Bond Market Considerations

At the beginning of the year, we alerted readers of our Outlook to be sensitive to the risks of investing in U.S. Treasury, corporate, and tax-exempt bonds. Our view rested on the historically low yields provided by these bonds at a time when the economic expansion was maturing and inflation was looming. We were also concerned about the U.S. government’s massive budget deficit and approaching debt ceiling deadline, highlighted recently by warnings of potential downgrades from credit agencies, and the very weak fiscal circumstances of many tax-exempt issuers. Our advice was to keep credit high and maturities short.       

                 

To our surprise, the yield on the benchmark 10-year U.S. Treasury note has declined from a high of 3.74% on February 8 to 2.95% on June 8, and corporate and tax-exempt yields have correspondingly declined. We attribute this drop in yields (and rise in prices) in part to growing uncertainty regarding the duration and severity of the current global economic “soft patch,” which has triggered an exodus from equities and a flight to the perceived safety of bonds in general and U.S. Treasury securities in particular. Another contributor to sliding yields has been the determined effort of the Federal Reserve to alleviate fears of inflation and keep rates low in hopes of accelerating economic growth.

Our forecast, shared by a consensus of economists, is that the “soft patch” will be relatively short and innocuous, as was the case with a similar “soft patch” at this time last year. A restoration of more healthy economic growth will most likely heighten inflation anxieties. We also expect the Federal Reserve’s “quantitative easing” policy (QE2) of purchasing Treasury securities to support low yields to expire in June and not to be extended.  Further, we expect worries about the U.S. government’s deficit to intensify as the debt ceiling deadline approaches. As a consequence, we reiterate our strategy of maintaining high quality and short maturities in U.S. bonds even though lower quality and longer-maturity bonds currently provide higher yields. We also suggest that readers consider the appeal of international bonds as an addition to U.S. bonds.

Our recommendation is echoed by Bill Gross, the celebrated manager of Pimco’s Total Return Fund, which is the world’s biggest bond fund. Gross, who according to  Bloomberg (6/9/2011) has outperformed 99% of his rivals over the past 5 years, eliminated U.S. government debt from his portfolio in February. Stating yesterday “I certainly don’t have any regrets,” he repeated his prediction that the 30-year bull market in bonds is over. Rather, he encouraged investors to consider the bonds of other countries with stronger balance sheets and half the debt. In particular, he cited the bonds of Germany, Canada, and Brazil, which have higher yields and he believes are safer credits, as “better opportunities.” 

We point out that many factors need to be considered in evaluating the appropriateness and desirability of international bonds, and currency fluctuations will have a significant impact. Investors who want to control risk should favor intermediate-maturity, attractive-yielding sovereign bonds of countries with strong economies and currencies. We are currently reviewing portfolios on a client by client basis, and we strongly advise other readers to seek professional assistance in diversifying their bond holdings by taking a global perspective.