The United States has avoided a default on paying its debts thanks to a last-minute deal forged between the two political parties on Sunday. But bond-fund managers warn that a downgrading of America’s credit rating by at least one of the three major credit-rating agencies remains on the table.
According to textbook financial theory, such a downgrade should have an immediate impact on pricing and on credit spreads that use US Treasuries as their benchmark.
That would suggest yields on the 10-year US Treasury bond would rise by 50-75 basis points, suggests Standish’s Tom Higgins. “But what’s the baseline?” he wonders, suggesting that lower economic growth and disinflation would also push yields lower, noting that Japanese government bonds yield just over 1% despite that sovereign’s downgrade (from triple-A to AA- by S&P and AA by Fitch).
Indeed, yesterday yields on the 10-year US Treasury tightened considerably, from 2.73% to 2.70%.
Part of the reason is lack of alternatives for global investors. Although there has been a surge in demand for Swiss francs, Canadian and Australian dollars, and gold, these lack the sheer depth and liquidity of the US Treasury market.
“I don’t see a liquidity issue arising from a downgrade,” says Jay Contis, vice-president at State Street Global Advisors. Very few investors’ guidelines would force them to dump Treasuries if the triple-A badge is lost. He expects Treasuries to remain the “default” benchmark, although there will now be discussion about benchmarks and how clients should formulate what is meant by ‘excess return’.
Bond managers in the US expect foreign investors over time to diversify out of the greenback, but this is going to be a slow process. Meanwhile, the Federal Reserve is pushing US financial institutions to raise their Treasury holdings, ostensibly to boost tier-1 capital, which would serve to prop up demand for Treasuries even if Asian central banks look elsewhere.
“I don’t think markets will care if there is a downgrade,” says Payson Swaffield, CIO for fixed income at Eaton Vance Investment Managers. “The US can still pay, it’s still the reserve currency.”
His colleague Thomas Luster adds that, in an environment of weak economic recovery, many investors will continue to favour Treasuries.
But Swaffield also believes the concept of the risk-free rate is changing, as investors now realise the US Treasury is not truly a risk-free instrument. Although Treasuries will continue to be the benchmark for most credit spreads, he says it is possible that certain blue chips – Wal-Mart, Microsoft, Johnson & Johnson – have the potential to trade through the sovereign.
Bond fund managers say the economic cycle will continue to have a far greater influence on pricing and spreads than a US downgrade.
Indeed, these corporations’ paper have seen inflows over the past few days, and bond chiefs in the US believe it’s just a matter of time before some of them trade at a premium to Treasuries.
Mike Roberge, chief investment officer and head of fixed income at MFS, says the securities most at risk are derivative areas of the market: triple-A rated municipal bonds, government-backed entities such as Fannie Mae and Freddie Mac, and financials. “They could face higher borrowing costs,” he says.
He also argues that the timing is premature for a credit downgrade. The latest deal is only the starting point for the US to come to grips with its indebtedness, a process that must also include structural reform of entitlement spending – something that a newly agreed bipartisan Congressional committee is supposed to address by November.
But committee recommendations can go ignored (although in this case, a lack of a deal would automatically trigger another $1.2 trillion of spending cuts). Any true assessment of the US political system’s ability to address its finances may need to wait until the 2012 elections. Americans now have clear political choices on the menu. How they vote will shape the manner of that restructuring – and determine the options for global investors.