What has happened?
Fitch has downgraded the long-term credit rating from 'AAA' to 'AA+'. The rating agency highlights that the action was due to the following:
Erosion of Governance - Standards of governance have deteriorated over the last two decades. Repeated debt-limited political standoffs have also eroded confidence in fiscal management.
Rising Government Deficits - Fitch expects the deficit to rise from 3.7% (of GDP) in 2022 to 6.3% (of GDP) in 2023. This reflects cyclically lower federal revenues, more spending initiatives, and a greater interest burden.
General Government Debt to Rise - Debt-to-GDP ratio at 112.9% this year, which is still above the pre-Covid 2019 level (100.1%). Fitch expects US debt-to-GDP to rise going forward.
Unaddressed Medium-Term Fiscal Challenges - Fitch expects a greater interest service burden given higher interest rates and rising debt stock. Fiscal spending should rise with the aging population and rising healthcare costs. Tax cuts set in 2017 are set to expire in 2025 but political pressure to make it permanent could mean potentially higher deficit.
Economy to Slip into Recession - Fitch expects the U.S. economy to slip into a mild recession in 4Q23 and 1Q24.
Fed Tightening - Fitch expects one more rate hike to 5.5% to 5.75% by September, adding further pressure on ratings.
Impact on US treasury yields and bonds
Fitch is now the second rating agency to cut the US long-term credit rating. Here's our take on the downgrade:
The rating downgrade does not mean that the debt repayment ability of the US is severely or immediately compromised. At ‘AA+’, the long-term credit rating is only a notch below the highest grade. For many investors, USTs remain a liquid, high quality asset. Even when the debt load becomes extreme, notwithstanding the potential consequences, “printing money” is always an option to refinance or avoid a default on USD debts due to an independent central bank and treasury department.
We see limited impact on US treasury yields (“UST”). Yields fell sharply after the downgrade in 2011 but we think the impact will be muted this time as:
- UST yields remain supported by resilient US economic growth and labor market data. Also, we see upwards pressure on yields from external factors like the recently announced larger US government issuance in 2H23 and higher JGB yields which are sapping demand from UST.
- Markets are highly focused on economic growth and inflation data which have been the primary influence on the UST yield’s direction largely this year. This should intensify with a data-dependent Fed, which means that the one-notch rating downgrade is unlikely to greatly influence UST yield.
- We expect minimal selling pressure on UST from the rating downgrade. For institutions (banks, hedge funds, pension funds, and insurance companies) that hold a large amount of USTs, sovereign debt rated between ‘AAA’ to ‘AA- ’ tends to fall within the same tranche of HQLA or collateral status based on international framework (i.e. Basel regulatory framework). Therefore, we expect no force-selling of USTs from these institutions as the asset remains within the highest quality, ‘AAA’ to ‘AA- ’ tranche even after the rating downgrade. For these institutions, UST remains important and unlikely to be quickly substituted given its liquidity, high quality nature, and depth of the market. That said, some ‘AAA’ only mandate funds may need to force-sell UST, but the impact is likely minimal as these funds does not have a significant market presence.
For bonds issued by US corporates, we see little to no direct impact, especially for AAA-rated issues as Fitch has retained the country ceiling at ‘AAA’. A downgrade in the country’s credit rating does not directly affect US issuers. For USD-denominated bonds, we see little to no direct impact as well. While the USD may experience some volatility in the near term, we think the downgrade alone will not exert major depreciation pressure on the greenback given the wide interest rate differential (with major central banks) and hawkish Feds.
Reiterating our recommendations
1. Stick with short-duration bonds
While we might be approaching the end of Fed’s rate hike cycle, we expect policymakers to hold rates at restrictive levels. Markets are expecting a more dovish outcome but we believe the Fed is right as 1) inflation remains persistent, with a slower than expected deceleration, and 2) policymakers are motivated to avoid any rebound in inflation caused by policy mistakes. This leaves policymakers with little room to take their foot off the interest rate pedal and the risk of rate hikes remains higher than cuts, making short duration bonds a prudent choice. Yields of short duration bonds have also risen substantially, with nominal yield looking much more attractive at the moment. For investors considering medium to long term bonds, we are see improving opportunities. That said, investors should be selective in adding duration.
2. Consider investment grade bonds
Given the global growth slowdown and our view of a US recession, we believe investment grade bonds (“IG bonds”) can provide stability to investor’s portfolio. In times of market drawdowns, IG bonds tend to be more resilient and outperform the risk assets like high yield bonds or equities. Yields of IG bonds have also risen greatly and are closer to 4% (gauged by Bloomberg Barclays Global Bond Aggregate Index). At current levels, the yield is near historical highs and provide investors with a real alternative to the stock market as well as many riskier bonds. IG bonds are also a better choice for investors looking for extra yield pickup over US treasuries.
The Research Team is part of iFAST Financial Pte Ltd.
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