On Friday evening, S&P downgraded its rating on US Treasury bonds to AA+.  This is a one notch downgrade and the first time ever that debt of the US government has not held the AAA rating.  In the ratings report, S&P cites the fight over the debt ceiling as demonstrating that meaningful reform on America’s long term fiscal problems is unlikely to happen in the short term.  S&P also reasons that the “fiscal consolidation plan that Congress and the Administration agreed to [last] week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.”  Basically, S&P sees that the US fiscal position is unsustainable in the long run.  From entitlements to deficit spending, changes must be made or the US will find itself unable to pay back its debts.  This is not new news.  In fact, this is a debate that has been discussed for years, but no serious action has been taken to address the problem.  S&P is simply reacting to the obvious.  It should be noted that the other two major rating agencies, Moody’s and Fitch have both maintained the AAA status, though they both have the US on negative watch for a potential downgrade.

In the short term, expect increased market volatility.  While markets have been very choppy lately, expect that to get worse as investors across the world process this change.  Most of modern finance is based on the premise that US Treasury bonds are the risk-free asset which serves as a benchmark for pricing all other risky assets.  Now that Treasuries may no longer be considered a risk-free asset, what is the effect on all other assets?  The market will have to sort this out over time.

The initial reaction around the globe has been to take risk off the table.  Equities in Asia and Europe have all sold off by ~2% on Monday with US equities looking to follow suit.  The most interesting reaction of all is in US Treasuries.  This is the asset that was directly downgraded, that was rated as being perceived as more risky by S&P.  Treasury bonds are rallying – up in price and down in yield.  This shows that even though they are no longer AAA rated by all major ratings agencies, the global market still views US Treasuries as a safe haven.  The fact remains, credit is relative.  Where else are investors going to go that is safer and more liquid than the US Treasury market?  There is still no other market in the world that offers the liquidity and safety of the Treasury market.

We at Acropolis believe that in the long run, markets are efficient.  This means that the best indication of an asset’s value, given all available information, is found in its market price.  Therefore, we would argue that the long run effect on US Treasuries will be negligible.  After all, S&P does not have any additional information on the US fiscal picture than does the market.  The market already knew about the polarized debate in Congress.  It already knew that deficit spending and massive entitlement obligations were unsustainable.  Therefore, everything that S&P cited as reasons for the downgrade should already have been reflected in the price of Treasury bonds as it was already public knowledge.  Now, in the short term, this announcement will cause increased volatility as it will have an effect on the psychology of the market (ex. stocks going down due to investors selling risk).  However, we firmly believe that over the long run, this will just be noise.

What is next?

We expect a ripple effect through the bond market.  The US Treasury is the backstop on many other bonds in the market.  Some municipals, Agency bonds and mortgage-backed securities (FNMA, FHLMC, and GNMA) will likely be downgraded to AA+ by S&P because they are backed by the Treasury.  Also, we would expect Moody’s and Fitch to follow S&P and downgrade their own ratings on Treasury bonds.  This means that this story will not go away soon and will likely get worse before it gets better.  This will likely take center stage in the 2012 election.  Thinking optimistically, this may provide the impetus for real change in the fiscal picture in order to avoid disaster in the long term.

For the long term investor, it is important to remember that markets are efficient.  There is nothing new in this announcement.  The credit worthiness of the US Treasury is the same today at AA+ as it was on Friday at AAA.  This is just the opinion of a group of analysts at Standard & Poor’s.  These periods of volatility can provide long term opportunities for those who stay the course and rebalance their portfolio.

Ryan Craft, CFA

Senior Investment Analyst