Implications of US credit rating downgrade

Written by Abhilash Narayan, CFA Senior Investment Strategist? 渣打银行

Fitch’s recent downgrade of US sovereign rating from AAA to AA+ came as a mild surprise for markets. Though Fitch had placed US debt rating on review for downgrade on 24 May 2023, few investors expected the downgrade to happen. Nevertheless, as I explain below, we believe that the impact on US government bond yields and corporate bond ratings is likely to be negligible. In fact, the recent spike in yields is a good opportunity to add exposure to long maturity investment grade bonds.

Old reasons for downgrade

Fitch’s downgrade of US sovereign credit ratings comes 12 years after a similar move by S&P in 2011. The primary drivers for both the downgrades were broadly similar – an erosion in confidence over US fiscal governance following partisan debt-ceiling showdowns and worsening long-term debt dynamics. Fitch cited the persistent US fiscal deficit and projected increase in the debt-to-GDP ratio as other factors supporting its downgrade.

While I don’t disagree with the reasons cited by Fitch, investors have known and closely watched the deterioration in US’ fiscal dynamics for several years. Hence, it was not surprising that the benchmark 10-year US Treasury yield barely moved a few basis points (one-hundredth of a percentage) soon after the downgrade.

In fact, if we look back at recent instances of a AAA-rated Developed Market (DM) sovereign bond downgrade, the knee-jerk sell-off rarely lasts more than a week. We believe that the current case is no different. Instead, it appears concerns about an increase in the supply of US government bonds this year have been a bigger driver for the recent increase in yields.

Fig 1: Historically, a sell-off in DM sovereign bonds after a credit rating downgrade has not lasted for long

US and France 10Y government bond yield changes; 0 denotes the day of the rating downgrade

Nowhere else to turn

Following the US rating downgrade, some of the most common questions we received were whether it would force institutional investors (pension funds, insurance companies) to sell US government bonds and rotate into other AAA-rated sovereign bonds, and whether we could see a flurry of downgrades for US corporate bond issuers. The short answer to both these questions is: no.

Despite the deterioration in the US’s debt dynamics, the reality is that investors have limited viable alternatives due to two key reasons:

1) Size: US government and corporate bond markets are the largest in the world. Prior to the downgrade by Fitch, US government bonds accounted for nearly 70% of all the AAA rated bonds in the Global Aggregate bond index (see table below). Their weightage was even higher in the US Aggregate bond index and the Global government bond or Treasury index. As a result, even if investors want to reallocate from the US into other AAA-rated government bonds, they are unlikely to be able to do so in meaningful size, especially given the market constraints.

Fig 2: Market value of major bond indices and AAA-rated bonds within those indices before and after US sovereign rating downgrade

2) Absolute yield: US government bonds are among the highest yielding segment of the Developed Market government bond index. Hence, rotating into other AAA-rated government bonds (such as German Bunds) is likely to come at a cost of lower yield, which is likely to limit any such reallocations.

Similarly, is we shift our focus to Investment Grade corporate bonds, the US corporate bond market dwarfs other markets in terms of sheer size. In addition, it is crucial to remember that Fitch affirmed US “Country Ceiling” at AAA. This technicality matters because it allows other US AAA-rated bonds (such as municipal and asset backed securities) to retain their current ratings and alleviates any downward rating pressure on US Investment Grade companies.

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Fed and supply-demand dynamics still key

Based on historical precedents and reasons outlined above, we believe the impact of US rating downgrade is likely to be minimal on US and global bond markets. In our assessment, Fed policy, which primarily depends on the US growth and inflation outlook, and the supply-demand dynamics of US debt are the key drivers for US government bond yields. The recent spike in 10-year and 30-year US government bond yields has been driven by US Treasury’s plans for larger-than-expected bond sales in Q3. While clearly a negative in the near-term, we believe that markets may be over-reacting to the news of higher bond supply.

?As growth and inflation continue to slow, we expect the Fed to cut rates in the first half of 2024, which should drive the 10-year US government bond yield towards 3.0-3.25% range. Hence, the recent credit rating downgrade notwithstanding, we believe the recent spike in yields offers investors a rare opportunity to add exposure to long maturity investment grade bonds and potentially capture capital appreciation on the back of lower bond yields (higher bond prices) over the next 12-18 months.