This article was taken from the August issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
Fitch Ratings recently took the unusual step of downgrading US government bonds from its highest triple-A rating to double-A, the next tier down. Citing “expected fiscal deterioration over the next three years” as the reason for the downgrade, the ratings agency also alluded to the recent debt ceiling crisis, which was only resolved at the eleventh hour, thus narrowly avoiding a default. Bond and currency markets were largely unshaken by the news, however, with no significant movements. The US stock market was already closed for the day when the announcement was made, so little market sentiment insight could be gained.
To understand the significance of what happened, it first helps to examine the ratings agencies and why their views are so influential in bond markets. There are three main bond ratings agencies: Fitch, S&P and Moody’s. There are others which have been established by governments and information providers, such as the Japanese government and Morningstar, but the big three are the best-known and have the largest share of ratings business.
These ratings agencies assess the likelihood of default on a bond issue, by request of the issuer, and award the bond a grade. As a credit rating is a reflection of the creditworthiness of the issuer, it will have a large impact on the issuer’s borrowing costs. As the likelihood of default increases, investors will require a higher yield to compensate them for taking on the additional risk.
Each agency has its own alphabetic grading scale, although they are broadly similar. All three consider a triple-A rating to be the highest they can award, indicating that they consider default risk to be remote. Countries currently holding this honour include Germany, Switzerland and Australia. The UK has lost its triple-A crown from most agencies and currently holds a double-A. Now joining the UK in this lower rating tier, the US Treasury will be able to commiserate with the Bank of England.
Let us also consider the size and characteristics of the US government bond market. As the world’s dominant economy, it will not come as a surprise that its bond market is correspondingly enormous. The outstanding issues are collectively worth US$26tn. In 2022 the government paid US$534bn in interest. Banks are one of the largest domestic buyers of US government debt, holding approximately US$4.2tn. The US government bond market is often used to deposit customer funds due to its safety and liquidity.
In 1917 the US established the ‘debt ceiling’ – a notional borrowing limit intended to encourage the federal government to be fiscally responsible. In the years since, it has been raised many times and is often a source of conflict between The White House and Congress. In 2011 President Obama attempted to raise the debt ceiling but was hamstrung by Republicans in Congress who demanded deficit reductions. The ensuing crisis led to S&P downgrading its own rating of US Treasury debt from triple to double-A, which it had previously held for over 70 years. So, this is not the first time US government bonds have been downgraded and the circumstances today are not dissimilar to what happened in 2011.
The recent troubles began in January, when government borrowing officially reached its existing debt ceiling of $31.4tn. The Treasury could continue to fund its obligations up to the 5th June, after which not all of its outstanding debt could be serviced – i.e. a default. After lengthy and contentious negotiations, Congress agreed to pass a bill to suspend the debt ceiling for two years, in exchange for a cap on federal spending. The bill was passed on the 1st June, mere days away from default. Ratings agency Moody’s has estimated that a default on US Treasury bonds could lead to share prices falling by a third, and perhaps prompting a recession as severe as that experienced in 2007-2009.
Clearly uneasy with the debt ceiling debate antics, Fitch referred to an ‘erosion of governance’ as one of the reasons for the downgrade in its assessment. The agency also highlighted a growing debt burden and poor growth projections. It forecasts a recession in the final quarter of this year and the first of 2024. So far, the impact has been slight, and the market has taken the downgrade in its stride, with benchmark 10-year yields rising by 0.04% in response to the news. When S&P announced its downgrade in 2011, the impact was minimal. A wholesale selloff of such an important asset class was always manifestly unlikely. The loudest noises instead came from the US Treasury. Secretary of the Treasury Janet Yellen issued a statement in which she described the downgrade decision as “arbitrary and based on outdated data.” She went on to criticise Fitch’s ratings model and emphasised the fundamental strength of the US economy.
With Moody’s now the last of the big three to maintain a triple-A rating, the Biden administration and those in the future will hope to hang on to this remaining fiscal honour. While the downgrade will have little impact on the Treasury’s day-to-day activities, or the prominence of the US government in international debt markets, the reaction of the Treasury speaks more to hurt feelings than a debt crisis – physically unscathed but perhaps just a little embarrassed.
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