The Impact of Downgraded US Debt
On August 2, 2023, for the second time in history, the United States long-term credit rating was downgraded by Fitch Ratings from AAA to a rating of AA+. So, what does that mean for the average investor? US Treasuries have traditionally been the gold standard for low-risk investment grade fixed income securities. Major rating companies like Fitch, Standard and Poor’s or Moody’s, determine how likely these securities are to default. Although Fitch downgraded US credit from AAA (the highest rating) to AA+ (one level below the highest rating), US Treasuries are still considered investment grade and far from what would be considered below investment grade like “Junk” or High-Yield Bonds.
The reasons Fitch Ratings stated for the downgrade were, “The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.” Fitch went on to state a “steady deterioration in standards of governance over the last 20 years” drove their rationale for the downgrade. This reasoning may sound familiar to some, because there has been only one other time in history that the US debt received a downgrade to a AA+ rating. In 2011, Standard and Poor’s gave the first ever credit rating downgrade to AA+, where it remains today, which caused the stock market to decline significantly. In 2011, the country again came close to defaulting because of negotiations in Washington. At that time, Standard and Poor’s also cited political discourse as a primary driver for their downgrade, stating, “We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.”
How this will impact investors in the long term remains to be seen. Initially, in the 2011 downgrade, US equity markets sold off quickly, down between 5-7% the day following the Standard and Poor’s announcement. The more recent downgrade caused markets to decline, however much more modestly with the S&P 500 down 1.38% immediately after the announcement. The consensus among most economists seems to be that this downgrade isn’t likely to have key economic or long-term effects on the economy or investment markets. Mohamed El-Erian, Chief Economic Advisor at Allianz, stated, "Overall, this announcement is much more likely to be dismissed than have a lasting disruptive impact on the U.S. economy and markets.” He went on to say the explanations for the Fitch downgrade are not new challenges for the US, much like in 2011 there was debt limit gridlock and last-minute negotiations in Washington.
From an investment perspective, rates on a variety of fixed income securities are likely to rise given the slight increase in risk and the markets may remain choppy as a reaction to the headline news. Although Fitch’s rate change would indicate they believe the US is more likely than before to default on their debt, it still would prove to be a very unlikely scenario.