Earlier this month, ratings agency Fitch downgraded U.S. Treasury debt from the top rating of AAA to AA+, their second-highest credit rating. Fitch cited a growing budget deficit and reduced confidence in governance after the debt ceiling standoff as the reasons for the downgrade.
And what did many traders do? You guessed it: they sold their stocks and bought Treasurys.
I guess they weren’t alarmed by that AA+ rating.
[By the way, Treasurys, or United States Treasury securities, are simply bonds issued by the U.S. Department of the Treasury. They come in different flavors and have maturities that run anywhere from 4 weeks to 30 years. Why they’re not spelled “Treasuries” remains a mystery.]
The last time a credit ratings agency downgraded U.S. debt was in 2011, when Standard and Poor’s (S&P) similarly moved the U.S. from AAA to AA+ after the 2011 debt ceiling brouhaha. Back then, S&P cited *checks notes* a growing budget deficit and reduced confidence in governance after the debt ceiling standoff as their reasons.
Of course, after the 2011 debt downgrade by S&P, the U.S. government launched an investigation into S&P’s role in the 2008 financial crisis by rating mortgage-backed securities as AAA.
S&P’s CEO stepped down a mere 18 days after that downgrade, so we’ll have to see how this go-round plays out for Fitch.
Should You Be Concerned?
Is this downgrade cause for alarm for investors? Hardly.
The debt ceiling debates now seem to be just another feature of our government. As I wrote back in February (and in September 2021), politicians would have to be profoundly foolish to allow the government to default. And I think we have enough history with all the sound and fury surrounding the debt ceiling debates to understand that it’s theater.
So, that brings us to the Treasurys themselves. As with any bond, there are risk factors that come into play for investors:
- Credit risk,
- Interest rate risk, and
- Market risk.
Credit risk is simply the risk that you won’t get paid back. When you buy a bond, you’re literally giving the bond issuer a loan. At the end of the loan (the bond’s term), the borrower promises to give you your original loan back.
[By the way, interest rate risk is the risk that your bonds will decrease in value with an increase in interest rates – we experienced that last year. Market risk is the risk that your bonds will drop in value should overall market conditions deteriorate. We’re focusing on credit risk here.]
Assessing a bond issuer’s creditworthiness is where these credit rating agencies come in. Buying a bond from someone with a AAA rating means that there’s a much lower risk that you’ll get stiffed by the lender.
However, if you’re borrowing from someone with a BBB- rating, well, you’d better ask for a much higher interest rate. Bonds with a rating in the B’s, C’s, or D’s are politely called “investment grade” or “speculative”. People less concerned with being polite call them “junk bonds”.
So, thinking back to the Treasury downgrade, it’s not like they’ve suddenly become junk bonds. The market for U.S. Treasurys is perhaps the most scrutinized in the world.
In fact, Mohamed El-Erian, the former CEO of bond behemoth PIMCO, asked of the debt downgrade, “Why now?” These debt ceiling standoffs are not new. And there’s still no other country that can replace the U.S. in terms of reserve currency.
So, the downgrade seems a bit arbitrary this time. In fact, the dollar strengthened after the announcement.
Takeaways
While U.S. Treasurys have been downgraded by Fitch, I still don’t see how they aren’t among the safest investments in the world. It’s always important to understand that a bond’s credit risk is never zero. But I have a hard time imagining that you can find something with lower credit risk than U.S. Treasurys, even with all the debt downgrade mess.
If the government continues to print money like it has recently, will inflation continue to be an issue? Sure.
Should you sell your Treasurys if you own them? Nope.
Should you change your investment strategy because of this? Nope.
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