By Ron C. Dugan, CFA, Vice President and Global Investment Strategist

After the market close on August 5th, Standard & Poor’s (S&P), a major credit-rating agency, downgraded the long-term rating for U.S. Treasury debt by one level from AAA to AA+. S&P left the short-term rating intact of A-1+, which is the rating for all U.S. Treasury bills and the highest rating available. On August 2nd, after the U.S. debt ceiling was immediately raised by $2.1 trillion and the spending cuts amounting to as much as $2.4 trillion over the next ten years were approved by Washington, two of the other major credit rating agencies, Moody’s and Fitch, affirmed their long-term rating of AAA for U.S. Treasury debt.

Clearly, the U.S. is not your average sovereign credit. While other sovereign credits have been downgraded in the past, a downgrade of the U.S. is unprecedented; and thus, it is difficult to predict the markets’ reaction. In spite of this issue, there is a strong demand for U.S. Treasury securities by investors given the current economic environment and market volatility as evidenced by the recent pricing strength in these investments. Nevertheless, noted below are some possible systemic effects following the downgrade in the U.S. Treasury credit rating.

First, a downgrade would imply higher interest rates if other things are equal. Several factors contribute to a country’s level of interest rates, including monetary policy, inflation expectations and growth expectations, but creditworthiness is certainly a large factor contributing to the interest rate a country must pay to issue debt. A downgrade could lead to higher borrowing costs for the U.S. government, and thus its debt service would become a larger portion of the U.S. budget. This could also lead to the downgrade of many related entities that are dependent upon the federal government for support as their ratings are linked to the rating of the federal government. This would include the FDIC-guaranteed debt issued by financial institutions, and the debt of other government-sponsored agencies such as GNMA. It is very possible that the debt of municipal issuers from areas that are highly dependent on federal spending, and whose economies are more volatile, could be susceptible to downgrade. This could eventually lead to those municipal issuers having more difficulty issuing debt or incurring higher interest costs to do so. Additionally, some corporate entities, such as financial institutions, could be affected as they tend to be tied closely to their sovereign country ratings given that financial institutions often hold significant amounts of sovereign debt on their balance sheets. The cost of borrowing could also increase for many consumer loans. Loans whose interest rate is tied to a U.S. Treasury rate could move higher if interest rates on U. S. Treasury securities rise. This could increase the interest costs of a variety of consumer loans including credit cards, home equity loans and mortgages. Higher interest costs could ultimately lead to lower consumer spending providing a headwind to the U.S. economy given the consumer represents roughly two-thirds of domestic economic output.

Second, other non-U.S. Government fixed income asset prices could be impacted as these securities are typically priced in relation to a comparable maturity U.S. Treasury security. Higher interest rates and the potential for weaker economic prospects could result in additional headwinds for equity market prices and greater equity market volatility. The combination of potential ratings action and the fiscal gridlock behind it could lead to added uncertainty in the financial markets.

Third, the U.S. dollar is the world’s reserve currency today, representing approximately 60% of the world’s currency reserves according to the International Monetary Fund. As such, U.S. Treasury securities are held in large quantities by international investors and foreign central banks, in addition to U.S. investors. Investor confidence has been shaken a bit by the U.S. rating downgrade. Also, certain investors with strict investment guidelines for holding only AAA-rated securities might be forced to sell unless they can adjust their guidelines.

Fourth, it is a matter of national pride. Being a member of the AAA credit rating club is exclusive. Now only 15 countries (Australia, Austria, Canada, Denmark, Finland, France, Germany, Luxembourg, Netherlands, New Zealand, Norway, Singapore, Sweden, Switzerland, and United Kingdom) can boast of a spotless credit rating.

On the other hand…

First, a downgrade from AAA to the AA range (AA+ to AA-) would still leave the U.S. credit rating at a very high level. Other countries with ratings in the AA category range include China, Japan, Belgium and Saudi Arabia. Regaining the AAA credit rating would not be simple to do, but it has happened before with both Australia (in the 1980s) and Canada (in the 1990s) having lost AAA ratings and subsequently regaining it. A significant first step for the U.S. to make in this regard would be to put a credible, long-term deficit reduction plan into place.

Second, the impact on the market for U.S. government debt may not be as serious as widely thought. Few investors are restricted to holding only AAA-rated securities and a rating of BBB- or above is considered to be “investment grade”. Generally, a lower credit rating is likely to mean higher borrowing costs, but only if other things are equal. We know from Japan’s experience in recent years that bond yields depend primarily on the outlook for short-term interest rates and the factors that determine this outlook, including inflation and growth prospects. Even a decade after Japan lost its AAA rating, ten-year Japanese government bond yields are still only around 1%, and the yen is as strong as ever. In this instance, only one rating agency (S&P) has downgraded the long-term credit rating. U.S. Treasury bonds are now “split-rated” investments meaning some rating agencies still see them as AAA-rated securities. S&P’s opinion is a rating of AA+ (one step below AAA).

Third, the U.S. has a much greater dependency on overseas investors owning its securities which leaves it more vulnerable than Japan to capital flight. However, there is still no credible alternative to the U.S. dollar as the world’s dominant currency, which means it is as good (if not better) than the home currency for many investors. The fiscal challenges that could undermine the yen are also large, the euro is under serious stress, and the markets for China’s renminbi assets are still years from being sufficiently open to world markets.

Fourth, when investors choose to become more defensive and take a lower risk posture, U.S. Treasury securities will continue to be in high demand. The broad-based availability, liquidity, and the backing of the “full faith and credit of the U.S. government”, will continue to be paramount tenets for investors seeking investments with a low credit risk and instant market access.