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• The Downgrade What You Need to Know

The Downgrade What You Need to Know

written on August 28, 2011 by Frank Fantozzi

 

Despite passing the debt ceiling and spending cut deal anticipated by the markets, last week's data and events pulled bond yields lower and left the S&P 500 now down about 10% from this year's high. The slide may seem all too familiar. Market participants are worried about a repeat of the 2008 financial crisis. While the message from the markets is important, in last summer’s soft spot, the 10-year Treasury Note yield fell below 2.4% and the stock market fell 15%, but no recession took place. Instead, as the market became too pessimistic on the prospects for growth in the second half of the year, stock returns and bond yields moved to new post-crisis highs. The Summer of 2010 is the more relevant comparison to the current market slide than the Summer of 2008.

Last Friday's news that one of the three U.S. rating agencies was downgrading the U.S. credit rating from AAA to AA+ hit the markets and sapped the gains fueled by the report of better than expected job growth in the month of July and positive revisions to the prior months. However, this should also not be a surprise, since the Standard & Poor’s, was telling everyone for the last several months that if the politicians in Washington would not cut the deficit by about $4 trillion dollars, it was going to lower the credit rating. The politicians with all their brinkmanship were only able to lower the debt spending by $2.4 trillion.

Is this a killing blow for a market and economy already suffering from a series of disappointments or a disappointing but lagging indicator of the pressure already reflected in the markets past and level of recent years? We favor the latter assessment.

Here we will present our views on the downgrade from; why it happened and what it means for investors and policy makers, and what is next for the market.

Why did it happen?

While the imbalance in the U.S. long-term fiscal situation is no mystery, the reason for the downgrade at this time is best left in the words of Standard & Poor's. The first news of a near-term potential downgrade came on April 14th of this year. Standard & Poor's rating agency stated, "We believe there is a material risk that the U.S. policy makers may not reach an agreement on how to address medium and long-term budgetary challenges by 2013; if an agreement is not reached,
and a meaningful implementation has not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker that of peer AAA sovereigns.”

On July 14th, the outlook for a downgrade became even clearer as Standard & Poor's clarified their position with the a statement: "The CreditWatch placement of the U.S. sovereign rating signals our view that, only to the dynamics of the political debate on the debt ceiling, there is at least a one in two likelihood that we may lower the long-term rating on U.S. within the next 90 days."

Standard & Poor's cited $4 Trillion in savings as part of the debt ceiling bill as a number that would be a trigger to avoid a downgrade. As it became apparent that a "grand bargain" around $4 Trillion was off the table, a downgrade by Standard & Poor's became likely.

On Friday, August 5th, the rumor of a downgrade announced that negatively impacted the markets. The announcement of the downgrade was delayed by the treasury pointing out an error to the Standard & Poor's in their calculations of $2 Trillion as it related to the size of the total debt to GDP ratio, which was a prominent component of their economic justification for the downgrade. Standard & Poor’s acknowledged the error and removed that component and focused on the political environment for the justification for their downgrade and announced it on Friday evening after the market had closed.

What Does It Mean for the Government Bond?

Historically, downgrade announcements do not mean much to the market. They have priced in the event that led to the downgrade much earlier. You can find plenty of evidence of this in the downgrades from AAA of large countries and companies over the past 20 years or so years.

Bond prices did not plunge as yields were flat to down when countries lost their AAA ratings in the past. There are a number of smaller countries that lost their AAA ratings, but they are not really comparable to the United States. The big three are Canada, Japan, and Australia, and are far more important comparisons. In both Australia and Canada, yields fell when the downgrade from AAA came after run-up in the month before. Both of these countries eventually regained AAA status. Yields also declined following Japan's downgrade from AAA.

In the early 1980s, 60 companies in the S&P 500 were rated AAA, today there are only four: Microsoft, Exxon Mobile, Johnson & Johnson, and ADP (Automatic Data Processing). In general, the downgrade from AAA came after the market had already reacted to the drivers that made the rating downgrade an obvious next step. Companies like Brookshire Hathaway, General Electric, and Pfizer all lost their AAA status during the recent financial crisis. But the markets had already priced in the prospects of these companies well before they were downgraded, having no reaction to the news when it finally came out.

We see the prospects of treasuries more influenced by the outlook for economic growth than by the downgrade. We do not expect sharply rising yields in response to their downgrade, but instead, a steady move higher over the remainder of the year as economic growth proves to be better than is currently being priced into the market.

Are there triggers that would cause a financial crisis?

There are not triggers stemming from the downgrade that will cause for selling of treasuries or a chain of events leading to a financial crisis. In fact, treasury yields may decline as investments seek safety and liquidity.

Nearly 50% the US government bonds are held by foreigners. The biggest holder of US government debt, China, holds US debt as part of their currency management and trade policy and growth strategy, rather than as traditional investments. They are not constrained by ratings as a condition of their holding. In fact, China's rating agency, Dagong, downgraded the US last year. Importantly, with no other high quality, liquid bonds or of sufficient size to absorb the demand and with other AAA-rated countries on review for downgrade, these investors have nowhere else to go.

The next largest holder is the US Federal Reserve, who is unlikely to sell the treasury bonds acquired on the quantitative easing program until it believes the economy is strong enough to absorb the potentially higher interest rates that would result from the sales.

Insurance companies are required by law to hold large portion of their portfolios in very safe and very liquid securities. They are generally allowed to hold US government bonds no matter what they are rated. For example, the New York life insurance state law stipulates obligations issued by "The United States of America or any agency or instrumentally thereof."

Money market funds will not have to sell. The US short-term debt rating has not been changed. Regardless, money market mutual funds must hold top tier securities with no stipulation for ratings.

Banks do not need to raise capital, as they were forced to do after the failure of Lehman Brothers which triggered losses that forced additional selling. This was made clear by the Federal Reserve, FDIC, and other bank regulators last Friday, "for risk-based capital purposes, the risk weight for treasure securities, other securities issued and guaranteed by the US government, government agencies, and government-sponsored entities will not change."

Even those entities that are required to hold AAA-rated debt can still hold Treasuries since two of the three US rating agencies still rate the United States as AAA. . Unless Standard & Poor’s cuts the credit rating further or Moody’s and/ or Fitch, also cut the US's long-term rating, both have reaffirmed the US AAA rating, the debt is still considered AAA.
What are the consequences?
The lagging nature of downgrades comes after the drivers have already been discounted by investors and reflected in the economy, do not usually carry much in the way of major negative consequences. However, there are some negative consequences that while not dire can pose some challenges and should not be completely overlooked.

First, a lower rating may mean that interest rates will be higher over the longer term as investors demand more yield for taking on the perceived risk of treasuries. However, this is not a near-term threat to economic growth or the market.

It is possible that the municipal bond market may be impacted. The 15 AAA rated states could be subject a modest downgrade given some funding sources that are dependent upon the federal government. It is hard to see what the market impact of this rating change may be; however, it is likely to be sizable.

A higher cost for collateral and rep, derivatives, and swap transactions may result from the downgrade. These agreements are typically collateralized by Treasuries. As a result of this downgrade, counter parties would likely have to post slightly more of these securities as collateral, slightly increasing costs.

The United Kingdom and France are likely the next countries to see downgrades from AAA. However, markets have discounted this outcome. French credit the default essentially an insurance policy against the risk of default; however three times that of the United States.

Finally, the United States is still on negative outlook despite having been downgraded to AA plus. Without additional actions to put the United States on a path of fiscal sustainability, the United States will likely be downgraded further. This could have ramifications for those entities required to hold AAA rated bonds even if the other two rating agencies do not change their ratings.

What does this mean for policy makers?

Downgrade adds another point to fuel the increasing decisiveness between the political parties. In addition, Timothy Geithner, who is already considering leaving his post as Treasury Secretary, as is common after more than two years, may have to stay on so as to not appear as the scapegoat for the downgrades.

Washington has repeatedly shown the ability to miss opportunities that add the long-term US fiscal imbalance. However, perhaps the moment has arrived. Could a downgrade of the US credit rating be a Sputnik moment for policy makers? Probably not, but Washington has the ability to address this in November 23rd and December 23rd deadlines for agreement on finding the $1.5 Trillion in additional savings stipulated in the debt ceiling legislation and for Congress to pass them. They are tasked with finding a minimum of $1.5 Trillion, but there is no limit on them finding more than $1.5 Trillion in savings. Two weeks ago, a bipartisan proposal delivered by the Republican Speaker of the House, Jon Boehner, and the Democratic majority leader in the Senate, Harry Reed, to save nearly $4 Trillion over the next 10 years was rejected by the president. Could that plan get dusted off and new support in light of the downgrade? The market would welcome a larger bipartisan plan.

What is next for the market?

The announcement of a downgrade of the US credit rating from AAA to AA+ added to the list of disappointments investor have suffered in recent months, including: softer economic growth (although the data has been more mixed than consistently weak as it was last week), European debt problems spreading, and Washington's debt ceiling demagoguery.

The initial beneficiaries include precious metals and treasuries given the hit to investor sentiment and the desire to seek safety and liquidity. AAA rated German Bunds may also be winners as investors see quality while the debt of France and the United Kingdom may suffer as investors price in the likelihood that they are next in line for a downgrade.

Stocks may suffer from investors seeking a safe haven. Stocks may go down due to some selling as investors who own treasuries to diversify risk position in their portfolio may want to sell more stocks to recognize that their treasury holdings are riskier. Amongst stocks, the banks may suffer the worst, not that they would have to raise capital, but since not only is the "Washington put", or the willingness of policy makers to intervene with a bailout to avert a crisis, already called into question but now its ability to backstop a failure is also questioned.

However, stock prices reflect a wall of worry. Stocks are inexpensive on both a trailing and forward basis compared to history. The S&P 500 trailing price earnings ratio measuring earnings over the past four quarters is 13, the lowest since 1990. The S&P 500 forward price earnings ratio using earnings forecast over the next four quarters is 11, the same as it was at the bottom of the financial crisis in March of 2009. While valuations could compress further, the spring is already tightly coiled.

The solid second quarter earnings season suggests the market is too bearish with the prices it is putting on earnings. Notably, Standard & Poor’s indicated it is not planning on downgrading company's AAA ratings despite the agency's policy not to have a company's rating to be higher than its home country's sovereign rating.

Finally, while much of the world has been focused on a downgrade of the United States by Standard & Poor's, the more important credit situation for the world economy is Europe right now. Italy and Spain have been under intense pressure recently, after the debt crisis, for the peripheral nations of Greece, Ireland, and Portugal, was addressed with a second rescue package for Greece. This past weekend, the European Central Bank (ECB) announced plans to buy Italian and Spanish debt in the market pending fiscal reform commitments. Rather than tap the European Financial Stability Facility (EFSF), which has a flexible mandate but limited funding, the ECB has stepped in. Unlike the EFSF, the ECB has a scale to address bond markets of countries the size of Spain and Italy.

The stock market is likely close to making the low point of the year as events in Europe stabilize and earnings and economic growth prove better than the now overly gloomy expectations priced in for the third quarter. And important disclosure: The opinions voiced in the material are for general information and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All the indices are unmanaged and cannot be invested into directly.

Bond is subject to market and interest rate risk if still prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.

Government bonds and treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.

Precious metal investing is subject to substantial fluctuation and potential for loss.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

The economic forecast set forth in the presentation may not develop as predicted, and therefore can be no guarantee that strategies promoted will be successful.

The Standard & Poor's 500 Index is a capitalization - weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market values of 500 stocks representing all major industries.

Stock investing may involve risk, including the loss of principal.

Financial sector: Companies involved in activities such as banking, consumer finance, investment banking, and brokerage, asset management, insurance and investments, and real estate, including REITs.

An obligation rated AAA has the highest rating assigned in Standard & Poor’s. The odds of its capacity to meet its financial commitment on the obligation are extremely strong.

International investing involves special risk, such as currency fluctuation and policy instability, and may not be suitable for all investors.

Debt to GDP is a measure of the country's federal debt in relation to its gross domestic product (GDP). In comparing what the country owes on what it produces, the debt to GDP ratio indicates the country's ability to pay back its debt. The ratio is a coverage ratio on a national level.

The PE ratio (price to earnings ratio) is a measure of a price paid for a share relative to the annual net income or profit earned by the firm per share. It's a financial ratio used for valuation: A higher PE ratio means the investors are paying more for each unit of net income, so the stock is more expensive compared to one at a lower PE ratio.

Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities rather than securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Securities mentioned herein are not a recommendation to buy or sell. All decisions should be based on your risk tolerance, time horizon, and overall goals. A credit default slot (CDS) is designed to transfer the credit exposure of fixed income products between parties. The buyer of the credit protection, where as the seller of the slot guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income securities to the seller of the slots.

Securities offered through LPL Financial. Member FINRA/SIPC.