Fitch (one of the big three Ratings Agencies—the others being S&P and Moody’s) reduced its credit rating on US bonds from AAA (the highest possible credit rating) to AA+ (the second highest credit rating). The company cited “a deteriorating fiscal position over the next three years and repeated down to the wire debt negotiations”.
This week we’d like to address this downgrade, the current state of US government finances and the potential impact on markets.
Credit Ratings
So, what are credit ratings and why are they important?
A Credit Rating is used by a debt issuer to provide a quick data point on the likelihood that they will default on their debts. The debt issuers pay the agencies to evaluate their financial position and issue a report on their credit quality which includes a rating. Usually there is a correlation between the credit rating and the interest paid on the debt.
As you can see from the table above, credit ratings decline in quality from AAA to D. Ratings at BBB- and above are considered investment grade with those below considered high yield or junk. Investors in investment grade debt tend to rely on ratings a lot more than those who invest in high yield bonds and use them to gauge relative credit risk among large debt issuers.
The ratings agencies are very good at evaluating corporate credit quality but less proficient when they are required to evaluate governments and structured products. Remember the disastrous AAA ratings on mortgage-backed securities during the financial crisis? So, while credit ratings on company debt are pretty good at estimating default probabilities, when it comes to countries are they even relevant?
US Downgrade
Fitch is effectively telling the federal government that they have a spending problem with this downgrade.
Over my lifetime, the US Federal Debt has increased from 31.5% of GDP and $540 Billion in 1975 to 118.5% of GDP and $32.6 Trillion today.
The US Federal Government has consistently spent more than it takes in.
Over the last five years, the deficit hasn’t been less than $1 Trillion per year. In their downgrade note, Fitch said “there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters”.
And now with interest rates rising, the amount the government must pay to maintain the debt is astonishing. In Q1 of 2023, the annual interest expense on the national debt was nearly $1 Trillion. When you consider that total federal government revenues were only $3.4 Trillion, then the interest bill is almost 30% of total US Federal income. Current federal government interest payments are now 3.6% of GDP vs. 2.4% in 2009.
If interest rates continue to increase, then we could approach the interest to GDP ratios of the 1980s—5%.
Given this deteriorating fiscal profile, Fitch decided it needed to downgrade US Debt by one notch to AA+.
Any Impact?
We don’t believe that markets care about the downgrade and don’t expect it to have any meaningful impact on financial markets.
This isn’t the first time the US has been downgraded. In 2011, S&P downgraded the country to AA+. While there was a bit of volatility in the month of the downgrade, most people came to ignore it. There are now only 9 countries with an average AAA rating and many including Jamie Dimon (CEO of JPMorgan Chase) have questioned how those countries which are reliant on the US for their security and stability can have a higher credit rating.
So, the punchline is this is a non-event. Most investors in sovereign (government) debt don’t rely on the ratings agencies and the US Treasury Bond remains the world’s preferred safety security.
