While the US narrowly avoided defaulting on its spiralling debt, concerns about a possible downgrade of the US credit ratings is likely to herald a post-triple A ratings investment world, say fixed-income experts.
Credit ratings agency Standard & Poor’s had previously called for more than $4 trillion in spending cuts and has declared it was a 50/50 chance of downgrading the US before the debt deal was reached.
S&P has since been conspicuously quiet on its views about the Washington deal that cuts up to $2.4 trillion from US budget deficits over the next decade.
But some analysts think that it is not if, but when, S&P’s downgrades the much-vaunted US triple A credit rating.
State Street Global Advisors senior managing director of global fixed income, Bill Street, expects the downgrade to occur after the dust has settled from political wrangling over the debt deal.
“I think they will come to a downgrade in the next quarter,” he says.
While a downgrade will create concerns among some funds that have existing mandates or policies requiring them to hold triple A rated debt, Street says the size, depth and liquidity of the US bond market means it is unlikely there will be a flight out of US Treasuries.
“There will be fund-specific and fund concerns where people have been requiring policy or mandated triple A investments but the reality is that there is only one rating agency that will downgrade, I expect,” Street says.
“Ultimately, if the world cannot buy a triple A-rated T bills then it will create concern and movement of funds in the short-term but in the long-run the world will adjust to a post-triple A rated world.”
Former under-secretary of the US Treasury for domestic finance and now BlackRock head of fixed income, Peter Fisher, (pictured) also believes a downgrade would have a knock-on effect to other borrowers.
“If the US were to be downgraded by one or more agencies, the odds are very high that there would be knock-on consequences of other borrowers getting downgraded – both corporate and public, in the US and overseas,” Fisher says.
“What really ends up happening is a downward shift of the entire spectrum of fixed-income securities. Additionally, although we do not learn any new information from a rating downgrade, a change in the credit rating by one or more of the credit rating agencies would be a signal to all types of investors to re-examine their risk appetite.”
Fisher says the economic outlook for the US will weigh more heavily on investors’ minds than the political machinations in Washington.
It is a view seemingly shared by markets, with the US stock markets falling sharply on Tuesday on the back of soft consumer spending figures.
“I believe the sharply revised first-quarter GDP number of 0.4 per cent is of greater significance than the recent debates in Washington,” Fisher said.
The impact that government spending cuts will have on GDP growth and the impact of the ongoing debt crisis on household and business confidence remain uncertain factors for investors, Fischer said.
He predicts the US Federal Reserve will begin to change its attitude about whether it wants to leave rates at record low levels in the long-term, and if a third round of quantitative easing is necessary to pump-prime the languishing economy.
According to Fisher, investors have three courses of action in responding to a possible downgrade:
- No change to investment guidelines would mean the average credit rating of an investor’s portfolio shifts down. It is, therefore, likely more risky securities would be sold and, ironically, more US Treasuries and other government-backed securities would be purchased.
- A move to higher quality, with investors taking the downgrade as a signal to raise the average credit quality of their portfolios causing in an even larger selling of low-quality assets.
- A shift down in quality where investor portfolios would shift down in credit ratings consistent with a US downgrade and other securities that are downgraded in tandem. This approach would reflect a change in the overall investable universe.
Fisher says a large number of investors have already decided on their approach given recent events, but a downgrade will prompt others to also consider their options.
Street says he expects investors to continue the trend of being more qualitatively focused on the construction of their fixed income portfolios, with more attention paid to designing exposures that more closely align with investor aims around liquidity and risk.
“People are aware that there are parts of Europe that are all triple A and you can have a core Europe exposure if you want a fixed-income exposure rather than expose yourself to the volatility of the peripherals,” he says.
“At the same time we are still seeing a lot of interest on the corporate, high-yield side because the balance sheets are that much stronger.”