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Fitch and the US debt downgrade: should investors be worried?

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Fitch ratings agency’s decision to downgrade US government debt this week started with a bang but ended with a whimper, having only a marginal effect on Treasuries.

If anything, yields slipped slightly as investors sought a safe haven and bought longer-term bonds to escape from volatility the decision briefly inflicted on stocks and some commodities. The dollar strengthened above the 50-day moving average.

The rating agency cited “a deterioration in the standards of governance” as it downgraded the US debt rating from triple A to double A plus. It noted that the wrangling over the debt ceiling earlier this year brought the US to the edge of sovereign debt default. Fitch also said it expected to see a further economic downturn over the next three years which is likely to weaken US government finances even further.

For all the drama – although it was far less than the S&P decision, when the second of the three big rating agencies downgraded US debt for the first time 11 years ago – the fallout is likely to be only a few basis points across US government bonds.

The US can just print more money

There is no denying that the US spending on its interest payment is phenomenal, it is getting close to $1 trillion per year. However, it would be wrong to conclude that the government needs to “find” that money to cover the payment. Instead, it will just print the money.

Also, Treasuries are the most widely used form of collateral in the world because they are, even after the downgrade, highly rated, and they form a very liquid market and compared with some other government debt, are governed by the rule of law.

The fallout could be felt to some small degree from the amount invested by some institutional investors, whose investment mandates stipulate minimum triple A ratings based on two out of three of the big credit rating agencies. Moody’s is now the only agency still maintaining this rating for the US sovereign debt.

Why the Fitch downgrade is likely to be a flash in the pan

One of the major groups of Treasuries buyers are commercial banks which use them as regulatory mandated liquid assets, as collateral, and also sometimes as an asset to hedge interest rate risk on their liabilities.

Based on the Basel regulatory framework there are no capital requirements for government bonds rated between AAA and AA-, meaning a downgrade to AA+ wouldn’t make any difference. In fact, most banks have an internal rating and typically assign a 0% risk to investment-grade rated domestic government bonds.

In a similar vein, pension funds and insurance companies, also major sovereign bond buyers, use long-dated government bonds to match their long long-term liabilities such as life insurance or pension payouts.

For pension funds the risk to return profile is very important because they not only need to hedge interest rate risk but also create returns over the longer run to provide pensions. Here again, US Treasuries will still be a preferable asset irrespective of being rated AAA or AA+.

Goldman Sachs analyst Alec Phillips sums its up well: “We do not believe there are any meaningful holders of Treasury securities who will be forced to sell due to a downgrade. S&P downgraded the sovereign rating in 2011 and while it had a meaningfully negative impact on sentiment, there was no apparent forced selling at that time. Because Treasury securities are such an important asset class, most investment mandates and regulatory regimes refer to them specifically, rather than AAA-rated government debt.”

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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