One of the big pieces of market news in recent days is the US credit rating downgrade by rating agency Fitch from AAA to AA+. This came as surprising news to many investors, who are wondering how this will impact markets, if at all. Credit rating decreases are nothing to take lightly, but their exact effects can be complicated in something as complex as financial markets.
What are credit ratings, what does a downgrade mean, and what do we think about this recent news are all questions we will review in today’s post.
What Are Credit Ratings?
Credit ratings are a common piece of information used when evaluating debt investments. In fact, when a debt investment doesn’t have a credit rating, that’s typically a sign of increased risk because a large credit rating agency has not taken the time to evaluate that debt at all. Independent rating agencies analyze and review different debt investments (like government bonds, municipal bonds, and corporate bonds) and determine the creditworthiness of the analyzed investment.
All debt ratings are judged on a scale. Each debt rating agency’s scale will look a little different, but they are often comprised of letters that are sometimes attached with a plus or minus sign after the letter string. Like school, the higher the letter, the better the credit rating, with ratings consisting of many As indicating a better credit rating that those of a lower letter.
A simple way to think about credit ratings is that they are like credit scores for larger organizations. The higher the rating, the more creditworthy the organization is deemed and the less likely they are to default based on the analysis of the agency. The better the rating, the sounder the debt, which usually means the interest rate that they pay is lower – similar to higher credit-rated individuals being able to secure lower-interest-rate debt than lower-rated individuals.
Also, just like with personal credit scores, not every agency will have the same score for every piece of debt. While they all provide generally around the same rating, each agency acts independently, meaning one agency can rate a debt higher or lower than another agency. This is why it’s big news when a credit agency lowers, or raises, its rating, especially on the largest economy in the world.
What Happened with the Fitch Rating Change?
Fitch is one of the largest credit rating agencies in the world, akin to Equifax, Experian, or TransUnion in the personal credit rating space. When they make a change – especially to a government as impactful as the US – that makes headlines. On August 1, they reduced the United States’ credit rating from their premier AAA rating – the highest rating they have – a tier down to AA+.
While AA+ is still an incredibly sound rating, it’s a signal of the concerns they are seeing with US debt and may foreshadow issues coming down the pike. In a nutshell, the rating decrease signifies a reduction in the confidence and soundness of US debt according to the analysis of Fitch, and Fitch alone.
Why Did Fitch Reduce Their Rating?
There are numerous reasons Fitch decided to reduce the rating of US debt, as outlined in the analysis posted on their website. They specifically discussed concerns with the forward outlook of the US and our ability to continue to pay our debts in the future. They cited a high, and growing, general debt burden, a divergence of governance related to AA and AAA peers over the past two decades, and repeated debt limit standoffs and last-minute resolutions as the primary reasons for the credit downgrade.
They also mentioned concerns with ongoing issuance and servicing of US debt in light of the recent increases in US interest rates. Higher interest rates not only mean you are likely to get higher rates on your bank accounts, but new debt issued by the US is at higher rates as well. The higher the rate of the debt, the more interest the US needs to pay. When the government borrows money, we pay that back with future tax dollars – or more debt. As our debt has continued to climb, this is projected to put a larger strain on future budgets as more revenue needs to be spent solely servicing the debt instead of on other things.
Despite interest rates increasing, the US government debt continues to climb. A common metric used to evaluate the debt risk to a country is the debt-to-GDP ratio. This evaluates the percentage of the total debt compared to the size of the economy as measured through its GDP (gross domestic product). Fitch cites the increase of this ratio from 100.1% in 2019 to 112.9% as a reason for concern, especially in a higher-interest-rate environment.
Although Fitch describes some serious concerns with the US medium-term debt outlook, they do concede that the US dollar remains the preeminent global reserve currency, which provides the “US government extraordinary financing flexibility.” While this is a significant benefit to the US debt outlook, their analysis still felt that when weighing the other risks, it still warranted a credit downgrade.
What a Credit Rating Change May Mean
In financial markets, there can sometimes be a big difference between theory and practice. In the case of debt, the theory is that with a lower credit rating comes more risk, and more risk means higher interest rates. All things being equal, an investor will receive less interest from a higher-rated debt than a lower-rated one because the expectation of receiving your initial investment back – your principal – is better on the higher-rated debt. So, when a credit rating changes to the downside, the expectation is that newly issued debt will be at a higher rate to compensate for the additional risk.
In the world of bonds, prices and interest rates move inversely with one another. As interest rates rise, the price of current bonds drops. This is because someone could buy a newer bond, with the same risk, at a higher rate. As an example, if a bond maturing in 10 years is issued at $1,000 and is paying 5% interest and a new bond of the same organization maturing in 10 years and issued at $1,000 is paying 7% interest, the price of the bond at 5% would drop and could be bought for less than $1,000.
While the theory is that a change in credit rating will change the prices of current bonds and interest rates of new ones, in practice this isn’t always true. In the case of credit downgrades, other factors need to be taken into consideration. Specifically, do investors believe the credit rating is accurate, and what other alternatives are there to the investment in question?
If investors believe the credit rating is wrong and the stated risks are overblown, there may be no changes to interest rates of the price of current bonds. Although rated as AA+, the bonds may still continue to trade as if they remained AAA. As for alternatives, if the interest rate of an AA+ bond is significantly higher than that of an AAA bond, the additional “risk” of the AA+ may be more than worth it for the higher rate paid.
What Do We Think About the Rating Change?
In short, like all things with investing, we at Milestone are looking at the long term. Despite the credit rating reduction by Fitch on US debt, we do not believe this warrants any change to our investment strategy at this time. We agree with Fitch that there are concerns with any investment, including US and any other country’s debt, but the rating drop does not materially change our outlook of the safety and security that US bonds have historically provided.
It’s important to consider that AAA is the highest rating that Fitch has for rating debt. Being the premier rating, there are relatively few countries that make that list to begin with. This includes many countries that we would typically consider relatively safe and stable that also do not have AAA ratings, like Canada, Japan, France, and the United Kingdom, just to name a few. Although the US no longer holds an AAA rating with Fitch, this is not necessarily something that is uncommon with the rating agency.
Also, unlike many other countries that are AAA or highly rated, we believe the US has other advantages that still make US debt the premier government debt in the marketplace. Like Fitch mentioned, the US dollar is still the preeminent reserve currency. This gives credence to the belief that there will continue to be ample demand for US debt in the near term, allowing us to continue to finance our budget. Another reason demand for US debt will likely continue to be high is that the US has increased its interest rates faster than many other developed countries, which makes US debt an attractive investment compared to other developed, highly rated countries. These two considerations make it extremely unlikely in the near term that the US will have trouble issuing new debt to finance the budget, even though additional debt will cost more to service in a higher-interest-rate environment.
Another strength of US debt is that we have complete control over our currency, which is the ultimate safeguard to an actual default (not paying debt). Although this would be potentially disastrous in a different way, in terms of inflation and belief in the money supply, the US can always print more money to meet the debt demands. While this is certainly not the best path forward, what it does provide is a significantly low risk of actually ever defaulting on debt. This ability to control the money supply is not true for all countries, even some highly rated ones. Countries like those in the European Union (EU) do not directly control their currency, but work as an organized group. This is why when Greece was having financial trouble years back, they did not have the option to print more money to meet their short-term debt obligations because doing so needed agreement from the other countries in the EU. They needed to work with the other countries in that conglomerate to come to a deal on how to service their debt. This would not necessarily be the case in the US because we control our money supply directly.
When looking at other developed countries, the US has significantly better projected short- to medium-term economic and demographic conditions. Compared to many European countries, the US population continues to grow and we continue to have younger people enter the workforce. While our population is trending older, it is not accelerating nearly as quickly as in many developed nations, which provides a positive outlook on our ability to continue to grow our economy and thus service our debt. As Fitch pointed out, the US debt-to-GDP ratio has increased considerably in recent years, but a growing economy can stave off future accelerations of this ratio – assuming debt does not rise faster. The economic and demographic benefits the US has compared to many of our peers still makes US debt look comparatively favorable to other developed countries.
This Is Not the First Rating Cut
Having the US’s credit rating cut is not something that happens often, which is why it was such big news. Although there isn’t much history to look back on, the US had its rating cut in 2011 by S&P. While past performance does not guarantee future results, especially with such a small sample size, it still may be helpful to look at what happened last time around for clues about how things may play out this time.
When S&P cut the US credit rating from AAA to AA+, that was enormous news at the time. The US had never had a rating cut and was considered the premier debt in the world. There were many questions about what this might mean for issuing new US debt and what would happen to the markets in general. When the US credit rating was cut in August 2011, all the way until the market low in October of that year, the S&P 500 dropped approximately 8%. However, six months after the downgrade, the S&P 500 was up 12% and one year later 16%. Zooming out even further, from the 12 years since the S&P rating cut, the S&P 500 has averaged approximately 14% a year.
Based on this historical instance, there was some initial concern, but the rate cut had no long-term impact on the overall stock market. Looking at the bond market over that time span, the US government had no problems issuing, or servicing, new debt over that time period either. While past performance does not guarantee future results, based on the only other example we have in our history, there was no long-term detrimental impact on markets in general.
Hearing hyperbolic, jarring news like a credit downgrade can be scary. But it’s important to review the reasons the change took place and to zoom out and look at the bigger picture and what has happened before. Admittedly, there are certainly risks to the US economy and our overall debt situation, but based on our current circumstances and our future outlook, those risks still remain relatively small. There are much more important things to worry about, like what your own personal financial goals are and whether you’re saving enough to reach them, that should overshadow the headlines in the news.
Based on the reasons outlined for the credit rating change by Fitch and from our own personal analysis and experience, we strongly believe that no rash changes to your investment strategy should be made at this time. Of course, if your personal financial situation has changed, it makes sense to reach out to an advisor to review your situation. If you need help with your financial plan, please reach out to our team.