Understanding the Latest U.S. Credit Rating Change

On the surface, it seems significant, but we do not expect Moody’s recent downgrade of U.S. debt from Aaa to Aa1 on Friday afternoon will have much impact on financial markets. Prior to 2011, U.S. Treasury securities held the highest possible AAA ratings from all major ratings agencies. And by association, the debt of U.S. Government agencies like Fannie Mae and Freddie Mac also had implied AAA ratings.

Unlike the prior two downgrades, this Moody’s reduction is insignificant. The initial downgrade of U.S. debt occurred in August of 2011 when S&P downgraded the debt one notch to AA+. The S&P 500 stock index fell 19% in the days that followed, narrowly avoiding a bear market. At the time, the concern was over how many entities, and which portfolios could no longer hold Treasuries and agency securities and, as a result, what impact that would have on the entire global debt markets as all assets were priced relative to U.S. treasuries. There were going to be forced sellers of U.S. treasuries, which would cause the price of the world’s safe asset to fall for non-economic reasons.

However, unlike that initial downgrade, today, most contracts and investment policy statements have been rewritten to specify U.S. Government securities rather than AAA rated securities, meaning there won’t be any forced sellers because of this action. Second, the U.S. dollar remains the reserve currency of the world. To the extent investors want to hold secure positions denominated in dollars, the U.S. Treasury market still represents the safest option, regardless of rating. And finally, historical data suggest there is not a material difference in default rates between Aaa rated bonds and Aa1 rated bonds over a five-year window. In other words, not much is expected to change as a result of this downgrade.