By FPA member David Zuckerman, CFP®, CIMA®
Last Updated: August 15, 2011
Recently the credit rating for U.S. treasury bonds was downgraded by Standard & Poor’s (S&P) for the first time in history. Now that U.S. government debt no longer enjoys the highest possible rating, many investors are wondering about the ramifications of the downgrade. How much do you know about credit ratings and the impact they have on your money?
What is a Credit Rating?
A credit rating is an opinion on the creditworthiness of the issuer of debt. The financial health of governments, municipalities, and corporations that issue debt is evaluated by credit rating agencies that issue letter grades ranging from AAA to D. AAA rated bonds are considered the most secure investments, while anything below BBB is considered too risky to be classified as “investment grade.” Mathematical formulas are not the sole basis of credit ratings, as credit rating agencies typically analyze and evaluate both quantitative and qualitative factors when rating an issue.
How Are Credit Ratings Used?
Credit ratings can be used by investors to evaluate the risk of different bonds. Conservative investors seeking reliable streams of income from financially stable issuers tend to favor highly rated bonds, while aggressive investors seeking higher returns may opt for bonds issued by entities with lower ratings. Generally speaking, bonds that carry higher ratings typically pay less interest than bonds with lower ratings. Lower rated bonds typically pay higher interest in order to compensate bondholders for their increased risk.
What Are the Limitations of Credit Ratings?
A credit rating is a grade that reflects the opinion of a credit rating agency. How much does the opinion of a credit rating agency matter to you? In answering this question, you should first consider how reliable these agency ratings have been. The major credit rating agencies have been uniformly maligned for their role in the 2008 financial crisis where they gave risky, mortgage-backed securities AAA ratings and then downgraded them to “junk” status within just a few months. It is alleged that some of the models they used to rate these mortgage-backed securities actually assumed that home prices would never decline. In view of the savings and loan crisis and the home price declines in the early 1990s, this was a major failure of judgment. Currently many investors are struggling to understand how debt issued by Italy’s government can carry an A+ rating from S&P when market prices and interest rates indicate that a “junk” rating may be more appropriate.
Accordingly, many investors have reduced their reliance on the rating agencies and conduct their own due diligence.
What Does the U.S. Debt Downgrade Change?
Most investors are well aware of the financial difficulty facing the U.S. government and that many institutions conduct their own credit analysis of bonds. So for many market participants, the S&P downgrade will not change anything. Could the downgrade result in higher interest rates that may affect your portfolio? As recognition of the U.S. government’s financial problems becomes more widespread, interest rates could rise. But any such rise would be due to the perceived risk of future inflation and currency devaluation, not default risk. In fact, with interest rates near record lows many investors have been expecting higher interest rates; but the increasing threat of prolonged slow growth, or even recession, now trumps this expectation.
One “technical” fear regarding the downgrade stems from the fact that some companies have rules mandating that a certain percentage of their bond holdings must be AAA rated. Since only one of the major rating agencies has issued a downgrade, such “forced selling” is not likely. The downgrade is also not likely to change the fact that U.S. treasuries are the security of choice during times of crisis, as the liquidity provided by the U.S. treasury market is unparalleled. While markets often react to headlines, it will be long-term economic fundamentals that are entirely unrelated to the S&P downgrade which will determine interest rates.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles. He serves as Director of Public Relations for the Los Angeles chapter of the Financial Planning Association.