The United States Debt Scores Downgrade – Should I Stress?
Amidst the US tariff-focused headlines, one might be forgiven for missing the other crucial event in May – the downgrade of the United States sovereign credit score. This latest downgrade implies that all three major rating companies now rank the United States lower than their highest possible ranking. Should this be a concern for us?
There is an ongoing philosophical argument regarding whether United States government bonds can still be considered a measure of the ‘safe’ rate that forms the basis of the pricing of many assets across international financial markets. At a more practical level, however, we still believe that more mundane drivers, such as the outlook for economic growth and inflation, are likely to dominate as drivers of bond yields.
Insights from Financial History
In their book ‘This Time Is Different,’ Harvard professors Carmen Reinhart and Kenneth Rogoff examined financial crisis data over the past eight centuries, focusing on sovereign defaults. According to their research, history reveals two insights particularly relevant to today’s scenario.
- Sovereign defaults are surprisingly common throughout history.
- Unsustainable levels of debt can persist for extended periods.
Periods of credit stress tend to occur in clusters with prolonged periods of relative stability in between, often around significant events such as major conflicts.
Considerations for Investors
While the debate for and against holding US assets continues, finding a viable alternative to the US government bond market remains challenging. The market’s depth and liquidity make it difficult to replace, leading to ongoing demand despite current ratings.
Despite the downgrade, US sovereign bonds are rated just one notch below the highest possible grade, indicating minimal default risk. Fundamentals of growth and inflation are expected to drive US bond yields more than the ratings action itself.
Key Questions for Investors
- Are current bond yields attractive for investors to consider adding exposure?
- What are the primary risks to US government bonds?
The main risk is not the ratings downgrade but inflation. Rising inflation expectations due to US tariffs could significantly impact bond yields, especially if stagflation becomes a concern. However, the current economic slowdown and job market conditions may mitigate temporary tariff-driven inflation.
Based on the analysis, it is a favorable time to include US government and other Developed Market high-grade bonds in investment portfolios. Returns are above expected levels for the next year, making them appealing. Hedging against inflation risks can be achieved through US inflation-protected bonds.
