Standard & Poor’s (S&P) has downgraded U.S. Treasuries to AA+ from AAA. While this has been discussed for several months, the announcement yesterday evening came as a bit of a surprise.
The question is, what does this mean for you? The truth is that I am not really sure, and neither is anyone else, regardless of how confident they may sound about their theory. This has never happened in the U.S. and no one really knows exactly what is going to happen. I can tell you that Iron Capital’s investment committee is going to meet via teleconference Sunday evening and again very early on Monday morning. We will determine what, if any, action is appropriate and be ready to act when markets open.
In the interim I can shed some light into the real issues at hand here. Let me start by reminding everyone that credit rating agencies’ opinions are exactly that, opinions – nothing more, nothing less. S&P has just announced that it is their opinion that U.S. Treasuries are not as safe as they once were. We have been announcing that opinion for two years now. Someone stating their opinion does not actually change reality. The U.S. government is not more likely to default on their debt today then they were yesterday, before the downgrade. Unfortunately, while downgrades don’t change reality, they can shift the perception of reality, and that may be more important.
The textbook response to a downgrade would be a sell-off in the bond market as people sold the downgraded securities, which would result in higher interest rates. Undoubtedly you will be hearing about the dangers of higher interest rates from media talking heads. This is certainly a possibility; however, recent bond market behavior would indicate that this is not likely. On June 30, the ten-year Treasury had a yield of 3.22 percent. At yesterday’s close that yield was down to 2.56 percent. That lower yield means a higher price, and that means investors have been buying Treasuries like they are going to stop printing them. This has happened while the biggest financial story of the last month has been the debt ceiling and the possible default and downgrade of Treasuries.
You all should know this, as I have been writing ad nauseum about the irrational behavior of the bond market. If the threat of default didn’t make interest rates rise, a downgrade may not either. In fact, Japan has been downgraded regularly over the last decade and a half or so, and they still have very low interest rates. However, there is a danger that some institutional investors may have to sell.
One of the biggest problems in the institutional investment world is rules-based investing. Too many plan sponsors think they can protect themselves from poor judgment by replacing judgment with rules. Nowhere is that more prevalent than in the investing of bond portfolios. Several states have even gone so far as to legislate rules into the state code for public pensions. This was a major contributor to the financial crisis and one that has not been addressed. Many pension plans will be forced to sell Treasuries, even though they may not want to, unless they can get these rules changed.
The credit rating agencies should have never been given that much power. Their ratings are no more meaningful than the buy or sell ratings of Wall Street analysts in the equity world, as was evidenced by the AAA rating of mortgage-backed securities. No one would ever write an investment policy that limited equity portfolio managers to stocks that had buy ratings, yet the industry does it all the time in the world of bonds. This practice needs to stop, and investors need to use their own judgment and conduct their own research. All the bond managers we use and recommend already do this.
There is probably time to get these rules changed as S&P is only one rating agency and the rules don’t usually state which rating agency the investors have to use. The selling may be less than expected because Moody’s and others still have the U.S. at AAA. However, since S&P has downgraded, the others will likely follow soon. If these rules can be changed, then drastically higher interest rates and a route in the bond market may be avoided.
Theory would also suggest no reaction in the stock market as this downgrade does not directly impact stocks. However, the stock market tends to be emotional and it is already at a low ebb. Some think the downgrade is already priced in, while others are sounding alarm bells. Either way, this is short-term. It has the potential to turn this correction into a bear market, or it could be nothing, but it will be the fundamentals of the actual companies – not the U.S. Treasury – that determine the long-run results in the stock market.
We know that news like this is scary. The media only make it worse, since they don’t want you to turn the channel. The first step in scary situations is to not panic, and I can assure you we will not do so. We are on top of the situation and will take defensive measures if necessary.
Chuck Osborne, CFA