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What Does The Downgrade Of U.S. Debt Really Mean?

Sentimental observations about the United States falling from a 94-year state of grace aside, Standard & Poor’s recent downgrade of the Treasury’s credit rating has real implications for investors and the nation.

In theory, a lower credit rating reflects a higher risk that an entity such as the Treasury will default on its debt or other financial obligations. To compensate lenders for the added risk, lower-rated borrowers generally need to offer higher interest rates. However, even though Standard & Poor’s now considers U.S. debt no longer worthy of the top AAA rating, Treasury yields—the gauge of how much interest credit markets demand from the U.S. government—actually declined during the week following the downgrade. Although it may seem paradoxical, global investors still consider Treasury debt the safest place on earth to park their money in times of heightened risk, no matter what the rating agencies say. No foreign central bank is dumping our bonds; if anything, they’re buying more.

In the longer run, if the Treasury fails to regain its AAA status, its reputation could eventually weaken, and U.S. interest rates may rise. On the eve of the downgrade, the two countries with AA+ ratings from S&P paid an average of 2.72% on their two-year bonds and 4.58% on their 10-year debt, compared with 1.12% and 2.65%, respectively, for the world’s remaining AAA borrowers.

But averages can be deceiving. Switzerland, which S&P rates AAA, pays just 0.06% in annual interest on its two-year bonds, and the United Kingdom, also AAA rated, pays fully 10 times as much—still a very low rate. And then you get to Japan, which S&P rates two steps lower at AA—a full step below where the United States is now—and pays only 0.15% on its two-year debt. That’s right: this lowly AA-rated country pays less than a quarter of what AAA-rated Britain offers, while interest rates for most other AAA nations are nine times as high as what investors are happy to get from Tokyo.

Incidentally, the worst-case scenario S&P currently sees for the United States would prompt one more downgrade during the next two years, which would put the Treasury at exactly the same level where Tokyo is now.

Any upward trend in U.S. interest rates would also have to overcome the Federal Reserve and its new policy of setting the low end of the yield curve effectively at zero through mid-2013. As we have seen several times during the past last few years, the Fed has almost endless funds at its disposal to buy Treasury debt and keep the government’s borrowing costs artificially low.

Of course, other U.S. borrowers lack the infinite resources of the Federal Reserve. In the S&P system, the new U.S. rating means most U.S. companies, state and local governments and other bond-issuing entities are now also subject to a maximum rating of AA+, and that has led to downgrades of many formerly AAA-rated borrowers. However, S&P has made numerous exceptions to its normal operating rules, leaving the AAA ratings on some states, cities, and corporations intact.

In explaining why it didn’t downgrade all municipal issuers, S&P noted that “the institutional framework for U.S. public finance is among the most stable and predictable in the world.” Meanwhile, the behemoths of American industry—including Johnson & Johnson, ExxonMobil, and Microsoft—are also considered unassailably reliable, and their AAA ratings are safe as well. And though the entities whose debt was downgraded may suffer over the short term, the pain need not be permanent.

Standard & Poor’s won’t speculate on when or how the United States might get its AAA rating back, but other nations—Germany, Sweden, and Canada, among others—have rebounded from downgrades. It’s often a slow process, taking as long as a decade, but if Congress can find the will to work out a sustainable budget that satisfies the ratings analysts, it can happen.

And that prospect in itself may be the silver lining in this situation. While Standard & Poor’s has been criticized by the President, Warren Buffett, and others for publicly challenging the will of one of the greatest economies on earth to pay its debts, the challenge may be an opportunity in disguise. Any nation that owes 74% of its annual gross domestic product could stand to look seriously at its budget. If nothing happens to change the way the government spends, Standard & Poor’s calculates that we would owe 101% of GDP by 2021, which would put us roughly where Italy is now.

This was a wake-up call. Now we can prove to the world how we became the greatest economy on earth in the first place.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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