Is US debt appealing after Moody’s downgrade?
As government debt in the United States has continued to mount, the credit rating agencies have sat up and taken notice. Moody’s is the last of the big three ratings agencies to strip the US of its highest rating, following in the footsteps of S&P and Fitch. Having held Moody’s Aaa rating for well over a century, US government debt has been knocked down to Aa1, Moody’s second-highest rating. So, there is now a consensus that US government debt is not as rock solid as it used to be, but why is this, and what impact do rating agencies, and their ratings, actually have in the real world of investing?
There are 21,000 different bonds in the Bloomberg Barclays Global Aggregate Bond Index. This index covers only 27 local currency markets, so we can deduce there are far more than 21,000 different bonds outstanding. To help people navigate the plethora of different bonds, the agencies assign a rating to individual bonds, as shown in the chart below. The ratings are subjective, although the agencies publish long methodology papers – that very few people read – to act as a guide.
The ratings are then split into ‘investment grade’ and ‘non-investment grade’, the latter often described as ‘high-yield’ or ‘junk bonds’. The main point is that, much like a rating system for hotels tells you how likely you are to get a good night’s sleep, the bond rating system is an intuitive, shortcut to gauging how likely you are to get your money back if you invest in a bond, without spending hours researching each issuer.
The ratings agencies are paid by the bond issuers, not the investors, and this potential conflict of interest has always been cause for concern. These fears came true in the lead-up to the financial crisis in 2008, when ratings agencies would offer favourable ratings to poor-quality Mortgage-Backed Securities because they feared issuers would simply go down the road to a competitor if it looked like they would receive a bad rating. Since then, the agencies have been conscious of their reputations, and though they occasionally get it wrong, on average a bond rated Aaa has only a 0.56% chance of going bust in the first 10 years of first being rated. A non-investment grade, Ba bond has 21.6% chance of going bust in 10 years, and a truly junky Caa bond has a 74.7% chance of going bust in 10 years. Fortunately, there are very few Caa-rated 10-year bonds to trouble investors.
So, US government bonds have been downgraded from Aaa to Aa1 – what does this mean? Historically, the chance of default in 10 years’ time has risen from 0.56% to 0.58%, which should not cause anyone to lose sleep. For once, the Trump administration’s reaction seemed understated when Scott Bessent, the Treasury Secretary, said of the downgrade: “Who cares? Qatar doesn’t. Saudi doesn’t. The UAE doesn’t… They’re all pushing money in and they’ve made 10-year investment plans.”
For reference, the UK and France are rated Aa and Japan and China are rated A. With the recent US downgrade, the only Aaa countries remaining are Australia, Canada, Denmark, Germany, Netherlands, New Zealand, Norway, Singapore, Sweden, and Switzerland.
When a normal corporate bond is downgraded one notch you would expect to see a slight up-tick in the interest rate it has to pay, provided it does not fall from investment grade to high yield or junk. For these ‘fallen angels’, as they are called, the increase in interest rate can be significant given that many funds and endowments are not allowed to hold junk bonds, and are forced to sell. Similarly, banks must set aside more capital to own lowly rated bonds, so they will often sell if they smell the possibility of a downgrade.
These rules do not seem to apply to US government bonds. The rules for nearly all funds and endowments permit the holding of US treasury bonds, without specifying a rating. There is an assumption imbedded in these rules that US government bonds are ‘risk-free’ as they are backed by the biggest, most powerful government in the world, one that has never defaulted on a bond since the country’s creation in 1783. Consequently, the market has looked through the Moody’s downgrade and ignored it. The driver of interest rates on US government bonds is not the credit rating, but the inflation outlook and the world’s demand for safe-haven investments.
Of course, it is not the ability to pay that is important, rather the willingness to pay. President Trump’s “big, beautiful” tax bill threatens to increase the annual government deficit to 9% of GDP by 2035; well in excess of the 3% deficit our own government is wrestling with at the moment. The projected rise in US government debt is shown in the chart below:
Source: FT
Ultimately, there will have to be a payback for the US in the form of higher taxes and/or lower government spending. The longer this goes unaddressed, the greater the pain later. It is this bleak outlook that Moody’s is highlighting with its downgrade, not the threat of imminent default.
Despite the hair shirt that the Americans will one day have to wear, we should not forget that it is a very rich country, with good growth potential, and, according to Moody’s itself, a “track record of innovation that supports productivity and GDP growth”. The likelihood of a default is very low, if only because US voters would not tolerate having a big chunk of their retirement savings wiped out. To paraphrase Winston Churchill’s famous quote: the US government can always be trusted to do the right thing, once all other possibilities have been exhausted.
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