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Repercussions of the U. S. Treasury Downgrade Across the Bond Markets by Beth Jones, RLP®

You can call Standard & Poor’s downgrade of long-term U.S. Treasuries whatever you want—unwarranted, politically charged, payback for past wrongs, or, given the government’s spending habits, a long time coming. The truth is that it happened, but Treasury investors don’t seem to care, as bond yields, which move inversely to price, have remained low. There are a couple of reasons for this.

First, for the time being, and probably for some years to come, many worldwide investors, institutions, pensions, funds, and governments consider the U.S. a safe haven. Second, all three rating agencies—Standard & Poor’s, Moody’s, and Fitch—have tended to have questionable credibility among the largest Treasury buyers because of inconsistencies in the rating scales and other hazy variables.

As a result, we believe that the downgrade has had, and should continue to have, little effect on bond trading. In the coming weeks, if volatility in Treasuries emerges, it is more likely to be the result of economic outlooks, global concerns, and safety plays, not Standard & Poor’s decision.

What about repercussions in other areas of the bond market?

Money markets. These investments are expected to remain unaffected. Only the long-term U.S. Treasury credit rating was lowered; the short paper that the majority of money markets purchase has continued to hold the A1+ mark, the highest possible rating.

Agencies. Due to their implicit backing by the U.S. government, it was only a matter of time before we saw the agencies (i.e., mortgage giants Fannie Mae and Freddie Mac) downgraded as well. Until the government decides what it wants to do with these enterprises, the rating of agencies and U.S. long-term debt is expected to remain the same. Performance in this space, however, will continue to be influenced by factors that existed before the downgrade: short supply and U.S. government dependency.

Municipals. The most significant effects from the downgrade may be felt in the municipal markets. Approximately 11,500 municipalities are tied in some way, shape, or form to the U.S. government and its funding—a fairly small number when you consider that there are more than 1 million municipal issues outstanding. Nevertheless, municipal debt pre-refunded by U.S. Treasuries, Build America Bonds, and federally funded school projects, along with low-income housing and other federally aided projects, may be downgraded.

Keep in mind that a downgrade doesn’t mean that funding has disappeared; these municipalities will continue to receive federal backing. The downside to a downgrade in this space has to do with mutual funds. Many fund managers have mandates that require them to keep a certain percentage of assets in AAA municipal bonds. Municipals that no longer meet that criterion will have to be sold. On the other hand, municipal funds make up a relatively small part of the overall market, so the effects of any downgrades should be minimal. Nine states hold AAA ratings from Standard & Poor’s, including Florida, and most, if not all, run deficits and budget shortfalls.

Corporates. Similar to what has happened in the agency space, some investment-grade corporate debt—particularly, banks and insurance companies—could be downgraded due to close ties to U.S Treasuries.

The corporate high-yield markets are highly correlated to the equity markets, which has led the space to sell off significantly in recent days.The downgrade could potentially put added pressure on credit quality, especially if the U.S. economy were to slump into another recession.

A waiting game
The markets are unpredictable at the best of times, and recent actions from the government and rating agencies have made them feel even more so, as nervous investors make knee-jerk decisions in an attempt to avoid losses. Bond markets have been less affected than equity markets, but only time will tell if or how future downgrades will play out.

Investors, therefore, should keep an eye to their long-term goals and avoid making decisions in reaction to near-term events without first discussing the potential implications with their financial advisor.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. This communication should not be construed as investment advice, nor as a solicitation or recommendation to buy or sell any security or investment product. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index.

Beth Jones, RLP® is a Registered Life Planner and Financial Consultant with Third Eye Associates, Ltd, a Registered Investment Adviser located at 38 Spring Lake Road in Red Hook, NY. She can be reached at 845-752-2216 or Securities offered through Commonwealth Financial Network, Member FINRA/SIPC.

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