Moody’s announced a change in its view of the U.S. Treasuries credit rating, with a downgrade from AAA to Aa1 on May 16. This follows other Nationally Recognized Statistical Rating Organizations (NRSRO), namely S&P and Fitch Ratings, who downgraded the U.S. Treasury debt to AA+ in 2011 and 2023, respectively.
This downgrade does not come as much of a surprise to those who monitor U.S. Treasuries because Moody’s had them on credit watch negative since 2023. Perhaps the real surprise with this recent announcement is the timing—during the final stages of federal budget negotiations.
To be clear, the downgrade by Moody’s was a decision based on a rising federal deficit, an increase in expected debt and a rising interest rate expense compared to other AAA-rated sovereign entities. While I’m not dismissing the real concerns that Moody’s has highlighted, I believe the impact of this downgrade will have minimal long-term effects beyond a temporary knee-jerk response since markets have already priced in this event.
Past Instances of U.S. Debt Downgrades
The first downgrade of U.S. Treasury debt by S&P on August 5, 2011, was a significant event. Ironically, it caused a rally in U.S. Treasury bonds. There was a flight-to-quality reaction after a widening of corporate bond spreads, a risk measure for non-Treasury assets.
In August 2023, when Fitch issued its downgrade, Treasury prices and spread levels were little changed. The market was not as surprised compared to the initial S&P downgrade.
Given these previous market reactions, the Moody’s downgrade by itself should not have any significant market reaction once the headlines fade. That said, it is uncomfortable to see such a downgrade. This will no doubt increase market volatility across the board for the near term, but I think it’s important to understand the significance of the U.S. Treasury market.
Why The U.S. Treasury Market Matters
According to the Securities Industry and Financial Markets Association (SIFMA), the U.S. Treasury market consists of $28.6 trillion dollars of bills, notes, bonds, TIPS and Floating Rate Notes (FRNs) with more than $1.1 trillion, on average, traded every day. The U.S. Treasury market is the largest securities market on the planet, offering unrivaled liquidity, transparency and stability. This has been tested time and time again as Treasuries are commonly referred to as the “risk-free asset.”
During periods of stress, the U.S. Treasury market has historically offered significantly higher levels of liquidity compared to other markets. (Liquidity in financial markets is the ability to transact without price disruption.) During the Great Financial Crisis in 2008 and the Covid-19 disruption in 2020, investors were able to trade U.S. Treasuries while other markets were inaccessible. The recent actions by Moody’s do not change these quality characteristics.
The U.S. Treasury market has a major impact on other bond markets, both domestic and abroad. In municipal, corporate, mortgage-backed and other securities, bond prices are quoted in comparison to Treasury yields and traded as a spread, or additional yield over U.S. Treasuries. Treasury securities are also used as a reference for other investments, futures and forward contracts.
As a result, changes in Treasury bond prices cause a cascading effect through global markets. There is no other substitute or reference security than that of the U.S. Treasury market. Despite this downgrade, the importance and significance of the U.S. Treasury market is unchanged.
Where Do U.S. Credit Ratings Rank Among Developed Countries?
Now that all three major NRSROs have a consistent credit viewpoint, it’s useful to revisit where the U.S. stands compared to other countries with similar and higher credit rankings. The chart below shows developed countries and their assigned ratings.
Within the U.S. domestic bond market, there are only two companies that have a higher, AAA rating according to Bloomberg: Microsoft and Johnson & Johnson, along with a handful of college endowments. However, within the municipal bond sector, AAA-rated bonds are much larger—over $294 billion in market value carry a AAA rating within the Bloomberg Municipal Bond Index. This is an interesting development, to have domestic issuers with a higher rating than the U.S. Treasury.
That said, comparing ratings with corporations and municipalities could be likened to comparing apples and oranges. The default probability of a non-sovereign entity that is unable to pay its obligation is different from that of a sovereign entity that chooses not to pay with its own fiat currency. While comparisons to other sovereign entities are appropriate, such comparisons to non-sovereign entities are less meaningful.
The Bottom Line: The Moody’s Downgrade Emphasizes Growing Concern About Rising U.S. Debt
The Moody’s announcement has certainly grabbed the attention of investors and the media. In my opinion, that is helpful in drawing attention to the real concerns around increasing U.S. debt levels and rising budget deficits, which I cautioned nearly a year ago.
Investors should understand that this action was highly anticipated and does little to change the dominance and leadership of the U.S. Treasury market. It will continue to be the largest securities market in the world, offering unparalleled execution, transparency and liquidity and will continue to provide a solid foundation upon which other global markets are built.
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