How Do the Chips Fall Now That the S&P Has Downgraded U.S. Debt?
by Patrick Faul, VP, Head of Credit Research, Calvert Investment Management, Inc.
"cred'it rat/ing, a classification of credit risk determined by a credit man or credit agency, based on investigation of a customer's or potential customer's financial resources, prior payment pattern and personal history or degree of personal responsibility for debts incurred." Webster's Encyclopedic Unabridged Dictionary of the English Language.
The recent credit rating downgrade by Standard & Poor's of the United States of America, from AAA to AA+ will have widespread repercussions. Standard & Poor's will now be going through their ratings and downgrading other AAA securities that are reliant on the U.S. AAA rating. Aside from the obvious ones, such as Fannie Mae and Freddie Mac, many state and municipal governments that are reliant on federal government spending will have their ratings downgraded.
Once the dust has cleared, expect two different effects that are negative for Treasuries. However, in the very short-term, the fear of the effects of the downgrade may have the ironic effect of yet another "flight to quality" into Treasuries.
The first effect will be a mechanical response from those who are obligated to hold only AAA securities. In a vacuum, we would expect this forced selling to push the prices of Treasuries down and push up the prices of remaining AAA securities. It is unclear how many investors have this restriction. Because the investable universe for these investors has just shrunk considerably, we expect many of these investors to rewrite and broaden their investment guidelines. This process will take time as presentations are made and investment committee meetings are scheduled.
The second effect will take longer to manifest itself. U.S. Treasuries have long been the base from which other investments are analyzed. Treasuries have been seen as riskless. When people want to reduce the risk in their investments, their knee jerk response has been to put money into Treasuries. The academic research that guides many investors and asset allocation strategies presupposes a "riskless asset." For U.S. dollar investors, Treasuries are used as the riskless asset.
Expect a gut-check: can you honestly consider U.S. Treasuries riskless? Alternatives are limited for U.S. dollar investors, but are wider for international investors. But even for international investors, what alternative has the size, liquidity and depth of the U.S. Treasury and Agency markets? There isn't one.
In the back of every investor's mind, there will now be a slight reservation about the safety of Treasuries. When they're staring at the dark ceiling in the middle of a sleepless night, will short T-Bills be the sanctuary that lets them fall back asleep?
This commentary represents the opinions of its authors as of 8/7/11 and may change based on market and other conditions. Their opinions are not intended to forecast future events, guarantee future results, or serve as investment advice. Accounts managed by Calvert Investment Management, Inc. may or may not invest in, and Calvert is not recommending any action on, any companies listed.
The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Calvert Investment Management, Inc. nor its information providers are responsible for any damages or losses arising from any use of this information.
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