Downgrade Q&A: Is AA+ So Bad? - WJS Blog

By Mark Gongloff

Q: What’s the difference between AAA and AA+? That doesn’t sound so bad.

A: It’s not so bad — and there’s not much difference. Technically, AA+ is considered “high grade” credit, while AAA is “prime.” The likelihood of getting paid back by a AA+ credit is considered “very strong,” while a AAA credit’s likelihood of paying you back is “extremely strong.” See the difference? Me neither.

And the U.S. is a special case, given its status as the world’s largest economy and printer of the world’s reserve currency. If your personal credit score falls, then you will almost certainly have to pay more to borrow. The U.S. can get away with a slight credit-rating downgrade without having to pay more to borrow. In fact, many other large, developed economies, including Japan, Canada and Australia, have lost AAA ratings in the past and not had to pay more to borrow in the long run.

Q: Luxembourg is rated AAA. Is the U.S. really a worse credit risk than Luxembourg?

A: No way. Luxembourg is a great country and a perfectly sound credit risk, but it lacks many of the advantages of the U.S., including the aforementioned economy and reserve currency, along with a very large printing press for that currency. If anything, this downgrade exposes some of the other discrepancies in ratings around the world. Should bonds issued by the European Financial Stability Facility, the entity set up to help bail out European sovereigns, really have a AAA credit rating, for example?

Q: Won’t some investors be forced to sell because of even this small downgrade?

A: Maybe, but not very many. Given the liquidity and relative safety of Treasurys, many regulators and money managers put Treasurys in a special category apart from rating considerations. Other managers are considering tweaking their rules to allow them to keep Treasurys.

U.S. banking regulators have confirmed that the downgrade will not force banks, which have big Treasury holdings, to raise any more capital as a cushion against losses. Short-term Treasury ratings weren’t affected, so money-market funds won’t have to sell

Q: What about foreign investors? Surely they’ll sell.

A: Probably, but they may not sell much. They’ve been trying to diversify their holdings for years, but they keep running up against an impregnable hurdle: They’ve got nowhere else to go. For better or worse, Treasurys are the largest fixed-income asset class in the world, by far, and the likelihood of default is next to nothing. The dollar is, for now at least, the world’s reserve currency, meaning foreign central banks will have to keep buying Treasurys. There’s really no other alternative available.

Q: What is the likely effect on interest rates, then?

A: Very hard to say, given all the cross-currents affecting markets right now. In a perverse sense, this downgrade has come at just about the best possible time for the U.S., despite the turmoil in the markets and anxiety about the economy. Those very uncertainties have driven investors around the world — including foreign central banks — to the safety of U.S. Treasurys, pushing U.S. borrowing costs to nearly their lowest levels in generations. So any increase in rates will come off a very low base. If interest rates rise half a percentage point, for example, that might put 10-year Treasury yields at 3% — still an extraordinarily low rate.

What’s more, the market has been bracing for this downgrade for a while, particularly on Friday, when rumors of it were widespread. It’s possible that most of the increase in yields has already happened. In any event, the history of Japan, et al, suggests that a downgrade might have no long-term impact on borrowing costs at all. Investors will likely respond more to inflation pressures, the direction of short-term interest rates and economic growth than to what one or more rating agencies say.

Q: Will this affect corporate-bond ratings or borrowing costs?

A: Not for most. Several AAA-rated insurance companies and some other financial firms with ties to the government are at risk of a downgrade, S&P has said. Most other corporate borrowers will be unaffected. Only four U.S. non-financial companies — Automatic Data Processing, Exxon Mobil, Johnson & Johnson and Microsoft — have AAA ratings. They will not be downgraded as a result of the U.S. downgrade.

Like the government, companies — including those with less-than-AAA ratings — have been borrowing at the lowest levels in decades. That is unlikely to change as a result of the U.S. downgrade. If anything, they could benefit as investors look for higher-yielding alternatives.

Q: How about the mortgage market?

A: S&P has warned it could downgrade government-backed mortgage agencies Fannie Mae and Freddie Mac, and we’ll have to take them on their word for that. Fannie and Freddie were effectively nationalized during the crisis and have the backing of the U.S. government. In theory, their downgrade should raise rates on mortgages across the country. But mortgage bonds have been in even hotter demand from investors than Treasurys lately, given their higher interest rates and government backing.

Kevin Cavin, mortgage strategist at Sterne Agee in Chicago, says the mortgage market may have already braced for the downgrade. While the unsecured debt of Fannie and Freddie might suffer, Mr. Cavin suggests, mortgage bonds, which have actual houses backing them as collateral, could stay in high demand.

In any event, mortgage rates have fallen to record lows recently, without sparking much of a boom in refinancing or new-home purchases. That means any small increase in mortgage rates will likely have little effect on the housing market.

Q: What about the muni market?

A: Here’s one area where there could be some real turmoil, though the long-term effects are difficult to discern right now. There could be widespread downgrades of municipalities that lean on federal backing, which could hit the muni market. The size of this impact, and its duration, remain to be seen, however. Just as Treasurys benefit from a scarcity of competitors, investors looking for relatively safe, tax-exempt bonds don’t have many alternatives to munis. That’s why many muni analysts think the damage could be small.

Q: Anything else?

A: There’s a grab bag of assorted debt that could get downgraded now, S&P has warned, including bonds issued under government lending programs established in the wake of the financial crisis, some ETFs, hedge funds and more. It’s difficult to say yet how far-reaching this will be or how much chaos it could cause.

Q: Any effect on the stock market?

A: This could cause some short-term turmoil as investors try to assess the impact, but that’s no sure thing. Some nations’ stock markets have quickly shrugged off downgrades in the past, notes Jason Goepfert at Sundial Capital Research, while others have not, so history is not much of a guide.

Coming just after the worst week for markets since the financial crisis in 2008, the timing for U.S. markets couldn’t be much worse. That said, there has been some warning that this was coming. And if investors determine the long-term effects will be manageable, any short-term market losses could be made up quickly. Like Treasurys, stocks will probably ultimately be affected by more than the rating agencies.

Q: Does anybody even take the rating agencies seriously? Didn’t they help cause this mess in the first place?

A: A downgrade is no doubt a psychological blow, a rebuke to the nation. Confidence in U.S. policy makers was already flagging, and this will not help. What’s more, some investors are a captive audience for the agencies, having to change their strategies based on what the agencies say. But it is true that the agencies contributed to this mess by failing to properly rate the mortgage-backed securities that were at the heart of the financial crisis. The government is so deeply in debt partly because of the damage done by that same crisis. The image of the rating agencies took a serious blow, and S&P arguably has not helped its reputation much with its handling of this downgrade.

If anything, this could lead policy makers and investors to take even greater strides away from their dependence on rating agencies, a process that began in the aftermath of the crisis.