S&P Downgrades U.S. Debt Rating – What You Should Know
Late Friday, S&P lowered its long-term credit rating on the U.S. to AA+ from AAA. The move was not entirely unexpected as Congress’ recent debt ceiling compromise fell short of the rating agency’s goal for more significant deficit reduction. However, this is a big news event since the downgrade marks the first time the U.S. has lost its AAA status since its initial publication 70 years ago. In addition, S&P put a negative outlook on the rating, which means that further downgrades are possible. So it’s likely the media will have some dramatic coverage.
While the news headlines may appear scary, the likely impact is short-term market volatility, not sharply higher interest rates that could hurt the economy. You may also hear about some municipal bonds, government agency bonds (Freddie Mac, Fannie Mae or TVA) or other securities closely tied to the U.S. debt rating being downgraded. This could happen the week of Aug. 8. Despite all the media coverage, here are some important facts to remember:
1. Downgrade Does Not Mean Default – Rating agencies such as Standard & Poor’s (S&P) and Moody’s assign ratings to bonds to help investors assess credit risk, or the chances that they won’t receive timely payments. A downgrade to AA+ means investors would be slightly less likely to receive future expected payments than if the bond had a AAA rating. That’s a big difference from default, which would mean investors don’t receive current payments.
2. U.S. Credit Rating is Still High Quality – It’s important to note that S&P didn’t change the U.S. government’s short-term credit rating (which applies to debt maturing in less than one year), which is more relevant for money market funds due to their short-term investment holdings. In addition, a long-term credit rating of AA+ is still considered high quality. In fact, according to S&P, a rating of AA “differs from the highest-rated obligations only to a small degree. The obligor’s capacity to meet its financial commitment on the obligation is very strong.” And remember, two other major rating agencies, Moody’s and Fitch, both recently affirmed their AAA rating on the U.S., although Moody’s has a negative outlook on its rating.
3. Downgrade Not a Big Surprise; Market Impact Uncertain – It’s not certain what the impact to the markets will be since this is the first time the U.S. debt rating has been downgraded. S&P communicated that a downgrade was possible well in advance of taking action, so the markets may have already priced in some of the impact. Here are some thoughts on how the various markets may react:
Interest Rates – While higher interest rates are a possibility, it’s important to note that when S&P downgraded Japan’s debt to AA+ from AAA in 2001, rates on 10-year government bonds didn’t change much. Canada’s didn’t change at all when Moody’s downgraded its debt to Aa1 from Aaa in 1994. In the U.S., rates on 10-year U.S. government debt have fallen significantly over the past several weeks despite the debt ceiling discussions and the fact that S&P placed the rating on negative watch a month ago.
Stock Market – Stock market volatility was already running high due to concerns over European debt and slower U.S. growth. The market may react negatively, but it will likely be short-term. Remember, many investors were already expecting a downgrade, so after the initial reaction to the downgrade, attention is likely to focus back on the economy and corporate profits.
Your Goals, Not the Media, Should Drive Your Investment Decisions
The market might react negatively to this in the short term, but our advice is to stay the course and not overreact to the headlines. In times of increased market uncertainty, it’s natural for investors to think they should “do something.” However, making big changes to your investment strategy could be expensive and may cause your portfolio to no longer be positioned to meet your long-term goals. Although it can be difficult to remember sometimes, long-term investors understand that short-term market declines aren’t a reason to overreact and can even present good opportunities to buy quality investments at lower prices.