After the markets closed on Friday August 5th, S&P lowered its long-term sovereign credit rating of the U.S. from AAA to AA+ and affirmed it’s A-1+ short-term rating. The firm also removed both the short- and long-term ratings from CreditWatch negative; however, the outlook on the long-term rating remains negative. Whenever an entity is placed on CreditWatch, it means that there is a high probability of a change to the rating over the near term, while the outlook refers to the longer term view of the rating.

Although this downgrade marks a significant event in the financial history of the U.S., we do not expect it to lead to a significant increase in Treasury yields over the near term. Additionally, because S&P reaffirmed it’s A-1+ short-term rating on the U.S., we expect a minimal impact on money market funds and other ultra short-term fixed income funds.

Rationale for the Downgrade

According to the S&P Research Update released on August 5th, S&P downgraded the U.S. credit rating due to the following factors:

• The recent debt ceiling agreement between Congress and the White House, which seeks to reduce federal spending by as much as $2.4 trillion over the next decade while also lifting the debt ceiling by a commensurate amount, falls short of what S&P believes would be necessary to stabilize U.S. federal government debt over the medium term.

• S&P believes that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened, as evidenced by the contentious negotiations over raising the debt ceiling, since the firm assigned a negative outlook to the long-term sovereign credit rating of the U.S. on April 18, 2011.

• Since assigning the rating a negative outlook, S&P has changed its view on the ability of the two political parties in the U.S. to successfully bridge the gap between their differing views on fiscal policy, which calls into question the government’s ability to leverage the debt ceiling deal into a broader fiscal consolidation plan that stabilizes U.S. federal government debt anytime soon.

Furthermore, because the outlook on the long-term rating remains negative, S&P could lower the long-term rating to AA within the next two years. Factors that could contribute to another downgrade include: less reduction in spending than agreed to; higher interest rates; or new fiscal pressures that lead to faster-than-expected growth in the U.S. federal debt. Although S&P downgraded the long-term sovereign credit rating of the U.S., the firm views the U.S. federal government’s other economic, external, and monetary credit attributes, which form the basis for the sovereign rating, as broadly unchanged.

Timing of the Downgrade

In addition to the rationale behind the downgrade, we believe it is important to understand the timing of the downgrade. Given that many of the issues cited by S&P have been building for months, if not years, many investors have questioned why S&P chose now to issue a downgrade. We believe that the timing was based largely on the following two factors.

• S&P was the only one of the three major credit rating agencies (Fitch and Moody’s being the others) who publicly announced specific aspects that they believed should be included in any potential deal to raise the debt ceiling. Specifically, in mid-July, S&P announced that any potential debt ceiling agreement should include at least $4 trillion in spending cuts to maintain the AAA rating of the U.S. When the debt ceiling agreement that was reached early last week included only $2.4 trillion of spending cuts, S&P was forced to downgrade the U.S. credit rating in order to maintain its integrity. Both Fitch and Moody’s, however, last week reaffirmed their AAA rating for the U.S. Therefore, we believe that S&P was forced to downgrade the U.S. based on its comments prior to the debt ceiling agreement.

• Although the U.S. federal debt situation is not expected to deteriorate relative to other AAA-rated countries until after 2015, it is clear that S&P issued the downgrade due more to current political issues rather than current financial issues. As made clear in the S&P Research Update that made the case for the downgrade, the real issue S&P has with the U.S. federal government’s debt situation is the serious problems with the political process in the U.S., including how it may lead to changes to the existing debt ceiling agreement and/or a failure to enact future fiscal changes that are required. For example, through 2015, S&P expects the credit profile of the U.S. to remain similar to Germany, France, Canada, and the United Kingdom, which S&P defines as appropriate peers; however, after 2015, S&P expects U.S. federal debt as a percentage of gross domestic product (GDP) to continue to increase, while the other AAA-rated countries are expected to decline. Therefore, it appears that S&P issued the downgrade now largely due to its concern about problems with the current political environment in the U.S. more than the current fiscal or sovereign debt environment.

Potential Implications

The next issue to consider is the potential implications on Treasury yields. Many investors fear that the downgrade from S&P will lead to an immediate, sharp jump in Treasury yields; however, we believe that this is unlikely to happen over the near term due to the following reasons.

• Forced Selling: Many investors believe that a downgrade of the U.S. credit rating will lead to forced selling by many investors, which would drive the yield on Treasury securities higher. Based on research from various sources, however, this conclusion seems weak at best. For example, most mandates that require fund managers to hold Treasury securities typically don’t specify that they must have a rating of AAA. Additionally, JPMorgan recently conducted a survey of asset managers and found that less than 5% would be required to sell some U.S. Treasuries in the event of a downgrade. As a result, JP Morgan believes that the downgrade should add no more than 5-10 basis points to Treasury yields in the immediate aftermath (1 basis point equals 1/100th of 1%). While we acknowledge that there might be some forced selling, we do not believe that it will occur to such a degree that it will lead to a sharp increase in Treasury yields over the near term.

• AAA-rated Alternatives: If current Treasury holders were to sell their holdings and move into securities that still maintain their AAA rating, their options would be somewhat limited. Prior to the downgrade, the U.S. guaranteed more than half of the world’s AAA-rated bonds. Additionally, while Canada, France, Germany, and the United Kingdom each maintain a long-term sovereign credit rating of AAA, the size of their bond markets pales in comparison to that of the Treasury market. For example, as of December 31, 2010, the total outstanding net government debt of the U.S. was about 1.6 times greater than the total of the four countries that S&P considers peers of the U.S. (see Figure 1). As a result, there are really no AAA-rated sovereign debt markets with the size and liquidity of the U.S. Treasury market that can serve as a viable alternative.

• Safe Haven Status: Despite being downgraded from AAA to AA+, U.S. Treasuries are still viewed as the safest and most liquid securities in the world. This makes Treasuries the preferred asset whenever uncertainty increases due to any number of reasons. Given the rising possibility for a double dip recession in the U.S., the continued sovereign debt problems in Europe, and the slowing economic growth in many emerging markets, we think that investors could continue to purchase Treasury securities due to this safe haven status. Therefore, Treasury yields could remain at their currently low levels despite the downgrade.

• Largest Holders of Treasuries: At the end of the first quarter, the largest holder of Treasury securities was the U.S. Federal Reserve, which owned approximately 14% of all Treasury securities outstanding (see Figure 2). The next largest holders were China (about 12%), the U.S. household sector (about 10%), Japan (about 9%), and state and local governments as well as pension plans (each about 5%). As a result, more than 50% of outstanding Treasury securities were held by these six entities as of the end of the first quarter.

While there could be some selling by the household sector, it is unlikely that any of the remaining entities will significantly reduce their Treasury holdings. The Federal Reserve has committed to keeping interest rates low in order to nurture the currently feeble economic recovery in the U.S., which includes a pledge to maintain its Treasury holdings that resulted from both phases of its Quantitative Easing program (QE1 and QE2). Additionally, it is unlikely that either China or Japan will significantly reduce their Treasury holdings because doing so would reduce the value of Treasuries and lead to losses for both countries. Lastly, state and local governments as well as pension plans typically own Treasuries for their income and their status as a risk-free asset. Although the S&P downgrade might call into question their risk-free status, Treasuries remain one of the least risky assets in the world.

Conclusion

Although we acknowledge that the S&P downgrade of the U.S. credit rating is a significant event, we believe that it could have a minimal impact on Treasury yields over the near term. A lack of forced selling, limited AAA-rated alternatives, the continued status of Treasuries as a safe-haven asset during this current period of slowing global growth, and the current composition of the largest holders of Treasury debt are factors that contribute to this opinion. Lastly, because S&P reaffirmed it’s A-1+ short-term rating on the U.S., we expect a minimal impact on money market funds and other ultra short-term fixed income funds.

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