US Credit Downgrade: What Does it Mean? And Why Does it Matter?

US Credit Downgrade

By now, I’m sure you’ve heard that Standard & Poor’s rating agency downgraded the US credit rating from Aaa to Aa+. While the other two ratings agencies (Moody’s and Fitch) have upheld the Aaa rating – at least for now – S&P’s decision to downgrade has sent shockwaves across the investing world.

While I don’t want this to devolve into a political argument, I do think it’s worth noting that S&P partly based their downgrade on the political dysfunction surrounding the debt ceiling debate in Washington. More specifically:

“The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed.”

Who cares about credit ratings?

Okay, aside from bragging rights, who really cares? After all, the US Treasury is just as safe (or unsafe) today as it was on Friday before the downgrade. Right? While that may be technically true, it’s all about perception.

The problem is that, if people start to lose faith in the “risk-free” nature of Treasury securities, borrowing prices will rise. In other words, investors could begin demanding higher interest rates to compensate them for the higher risk (real or perceived) associated with Treasuries.

Okay, got it. Higher rates. But who really cares about that? All of us should. Higher borrowing costs means that more of our Federal budget will have to be devoted debt service, and we’ll have to cut even deeper (and/or revisit the revenue [tax] issue) in order to get the deficit under control.

As for investors, rising interest rates will devalue existing bonds, causing losses in the bond market – though resulting in higher yields, and thus higher income per dollar invested. Also, the downgrade could create problems for money funds that are required to hold Aaa-grade investments.

Note: In the short term, Treasuries might actually benefit, as spooked investors flee the stock market in search of safer investments – in fact, that’s exactly what happened overnight, as bond buying on the international markets pushed rates lower (and prices higher).

And finally, for consumers… The downgrade could translate into higher mortgage rates, putting further pressure on an already weak real estate market. The same goes for interest rates on car loans, credit cards, etc. So yes, you probably should care about this, though it’s still unclear exactly how much of an impact the downgrade will have.

Which countries still have Aaa credit?

Now that the downgrade has occurred, you might be wondering who does have a Aaa credit rating. According to S&P, these are the 18 countries that still have sterling credit:

  • Australia
  • Austria
  • Canada
  • Denmark
  • Finland
  • France
  • Germany
  • Guernsey
  • Hong Kong
  • Isle of Man
  • Liechtenstein
  • Luxembourg
  • Netherlands
  • Norway
  • Singapore
  • Sweden
  • Switzerland
  • United Kingdom

If you’re interested in seeing the full list, as well as the Moody’s and Fitch ratings, check Wikipedia’s list of countries by credit ratings.

Are credit ratings reliable?

As an interesting aside, there are now four US companies that have higher credit ratings than the Federal government: Microsoft (MSFT), Exxon Mobil (XOM), Johnson & Johnson (JNJ), and Automatic Data Processing (ADP). Then Enron, Global Crossing, Bear Sterns, and others also had Aaa ratings right up to the bitter end.

Thus, you might want to view this whole ratings game with a healthy dose of skepticism. After all, ratings changes often appear to be reactionary – being based on things that have already happened – as opposed to offering a forward-looking perspective.

In the case of the US credit downgrade, it was no secret that a downgrade was looming. Thus, while the occurrence of the downgrade itself was unsettling, investors have had plenty of time to digest the likelihood that it would happen, and it should already be at least partially “priced into” the market.

This isn’t to say that the stock market won’t swoon – it probably will, at least a bit – but we’ve known for awhile now that the debt ceiling deal didn’t add up to the $4T in deficit reductions that S&P was looking for, and we already saw a lot of selling in the wake of that deal.

Note: I will wield a heavy hand on political rants, name-calling, etc. in the comments. Thus, while I encourage you to discuss the economic implications of the downgrade, I’m asking that you keep your comments respectful and on-topic, and that you steer clear of political discussion.

16 Responses to “US Credit Downgrade: What Does it Mean? And Why Does it Matter?”

  1. Anonymous

    We have not seen anything yet. I hope I won’t get into trouble for making this statement but I don’t feel it is a political one. I am not for democrats or republicans they are both doing the best job they can to collapse our dollar to bring in the New World Order. If Japan will loan a billion dollars to Walmart and then expect payment back in yein then we all should know something don’t smell right in the sewage.

  2. Anonymous

    As for blame, how about blame ourselves, the voters? We elected the people who put us in the fix, happily giving away our votes on unrealistic spending promises.

  3. Anonymous

    Yes, there’s plenty of blame to go around about what caused this – and there are so many parties who neglected to see what was happening for the past two years and did nothing. It’s like the US has developed an arrogance and I think other civilizations have failed because of that.

    I also think that each succeeding generation has expected entitlements. Just look in the workplace these days!

    Patrick, does anyone know why they’re not paying taxes? I don’t know. Could it be the median income level and amount of dependents? Or loopholes? Guess that’s why the Fair Tax is being brought forward – consumption tax?

    Has anyone pulled out of the market? Or still in because the drops are so great and selling makes your loss permanent?

  4. Anonymous

    I am not at all surprised at the downgrade, what amazes me is that the government has still not even talked about reducing the debt over the next 10 years. As mentioned earlier, the agreement reached last week just merely agreed to spend less.

    I am sick of reading all the slurs on the other pages, but something does need to be done about our current environment where half of the people in America pay no federal taxes. I understand everyone pays sale taxes, but it does raise the question of what good is collecting taxes from 1 man to give it to 4 others for doing nothing?

  5. Anonymous

    Of that list, note that Australia & Canada have had their debt downgraded – Canada in 1993, Australia in the 2000s (I think – it’s hard to research w/o getting an article about today’s mess). So it’s not the end of the world.

  6. LEH: Michael’s answer was excellent, I just want to follow it up with a simple (perhaps overly-simply) example.

    Consider a bond priced at $100 that is paying $10 in annual dividends (don’t I wish!). In this case, that bond has a 10% yield (= 10/100). If demand increases, and the price goes up to $110, then the yield falls to 10/110 = 9.1% (more or less).

    In contrast, if people fall out of love with that bond because of something like a ratings downgrade, and the price falls to $90 (i.e., they’re no longer willing to pay $100 b/c the perceived risk has gone up), then the dividend yield will increase to 10/90 = 11.1%.

    Assuming that you are reinvesting your dividends, then as bond prices fall, you will wind up buying higher yielding shares in the future which will (eventually) help to offset the decrease in share value.

  7. Anonymous

    One of the most valuable assets our country has enjoyed over the years is good and stable government. With the continuing polarization over deficit reduction, this asset has been eroded to the point that S&P specifies political leadership as one of the reasons for the downgrade. Economists have been examining the trajectory of our deficits and debt for years only to find the same conclusions time and again – entitlement spending must be reigned in.

    A decade ago, these problems were on the horizon and most policymakers were aware that they would at some time in the future need to tackle them. Unfortunately, the debacle that unfolded in the last decade (wars, housing bubble, sub-prime collapse, financial system stroke, and fiscal stimulus) sped up the timeline and policymakers weren’t up for the challenge. The public spectacle leading up to last Tuesday’s legislation was evidence that not only does America have a major spending problem, but she also has a palpable lack of leadership on the issue.

    The bottom line is until the issue of entitlements is addressed, there can be no substantive change in the trajectory that we find ourselves.

  8. Anonymous

    @LEH – In the near term, government bonds will appreciate as interest rates are pushed down by investors’ flight to safety. Over the long term (10, 20, 30 years out), government bonds are a near certain loser as interest rates will eventually rise.

    Just remember that when interest rates go down, bond prices go up and vice versa. Things that will increase demand for bonds will lower interest rates. The example playing out today is the stock market has become a risky place thanks to increasing economic uncertainty at home and abroad. As a result, investors are moving money from risky assets (stocks) to less risky assets (bonds). So, even with a credit rating downgrade, U.S. government bonds are still very safe relative to stocks. The net result is a drop in interest rates, a spike in bond prices, and a stock market that is looking for the next bottom.

    Hope that helps.

  9. Anonymous

    Um, Ginger, the Bush tax credits expired. They were extended by the current president so they are his tax credits. Most citizens suffer from poor math skills. If one took 100% of all the money from people that made billions and then 100% of the money from the people that made millions it wouldn’t pay off the debt owed, much less the increased tax rates that were under the former administration. Heck, even going back to the high tax rates of 50 years ago would hardly put a dent in the debt. The only way out of this hole is to stop digging (stop spending). That trillion plus per year spent on our offense department would be a start. It wouldn’t cost much to guard our country. I served for about 20 years with an average compensation of $10,000 per year per my social security statement in the armed forces so am hardly anti-defense. I am just anti-imperialist. But then most citizens want high defense budgets because all of the states have jobs for their workers appropriated via their congressional representatives.

  10. Anonymous

    If we are sticking to facts here and not political rhetoric then the most interesting financial statistic is that doubling the income tax of ALL Americans would still fall short of covering the $1.5 trillion budget deficit. Not having a budget DEFICIT should be the obvious answer here.

  11. Anonymous

    Can someone explain what this downgrade means to holders of Bonds mutual funds? I know you made mention of them in the article – but understanding bonds, interest rates, and movement of the market has always confused me!


  12. Anonymous

    I agree with Carol, the thing is that without increasing our input, there is no way for us to start paying off our debt. We need to start getting rid of the Bush tax credits. If I had my way, we would add a tax bracket for the higher income of about 1 million, then loose the Bush tax credits, but we do need to also fix the marriage penalty while doing so. By doing this, we should have a surplus again and can start paying down the debt.

  13. Anonymous

    While it’s disappointing that Congress got us into this mess, we deserved it. And the “agreement” they reached to cut spending was a sham. They only agreed to overspend by smaller amount, which is still in the trillions. For crying out loud, we have no right to deficit spend like that.

  14. Anonymous

    Don’t be surprised if interest rates for government securities continue to fall along with the value of the dollar in the short to intermediate term. I expect muni bonds, consumers and those living off of fixed incomes to get hurt the most. A healthy dose of inflation in the future is probably the only way out of this mess.

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