Investors hoping for a weekend's respite from the market tumult got a rude surprise late yesterday, when Standard & Poor's stripped the U.S. of its top-notch credit rating after the markets closed.
It's a move that affects far more than Treasurys -- in fact, Treasury securities may be the least of investors' worries. Analysts say the unprecedented downgrade could further shake investor confidence and lead to more stock market losses; the downgrade will also have consequences for municipal bonds and corporate debt. "We've never experienced anything like this before," says Stanley J.G. Crouch, the chief investment officer at Aegis Capital Corp. "We should examine our assumptions because things may not behave as people expect."
- What It Means for Investors
- S&P Removes U.S.'s AAA Rating for the First Time
- Video: What Will the Fallout Be?
- LIVE BLOG: Weighing In on S&P Downgrade
- S&P Press Release
- S&P Official: U.S. Downgrade Was Due in Part to Debt-Ceiling Brawl
- S&P Downgrades the U.S.: Five Things
Markets in Turmoil
For investors in or close to retirement, many of whom load up on bonds for both income and stability, the effects on all types of bonds are as important as the movements the stock market, advisers say. Of course, no one will know anything for sure until the markets open on Monday morning and the short-term fortune for the bond market will take more than a day to sort out. "The impact is probably more of a psychological one at first," says Anthony Valeri, a fixed income strategist for LPL Financial.
There are also mitigating factors. The ratings agencies have been telegraphing a downgrade for quite some time, leading some market observers to believe any effects have already been accounted for by the market. The Treasury's AAA rating has also been upheld by the other two major credit rating agencies, which means the S&P downgrade packs less punch, says Valeri. And investors may be so spooked by the recent volatility in the stock market that bonds, regardless of rating, may seem like the lesser of two evils.
Even so, investors are rightly concerned. Here are some of the likely consequences for bond investors in particular -- and the moves that experts say might be warranted.
In spite of the downgrade, Treasurys still represent one of the safest bets in the bond market and that means they may actually rally in the short term, as skittish investors find themselves with few other alternatives, says Crouch: "It doesn't alter the fact that Treasurys are a dominant asset class." Other pros, such as Rick Rieder, chief investment officer of fundamental fixed income for BlackRock, have said they would continue to view the U.S. as "one of, if not the, safest financial and economic system in the world," even in the event of a modest downgrade. Over the next few months, the downgrade is likely to raise yields on Treasurys by up to 0.5 percentage point, says Valeri. But for investors, yields are still low, especially on short-term T-bills the average one-year bank certificate of deposit currently pays 0.91%, according to Bankrate.com, far more than the 0.1% offered by a one-year Treasury.
The S&P downgrade creates a unique situation where some states are rated higher than the U.S. Treasury. (Congratulations, Florida!) Typically, Treasurys are considered safer than municipal bonds because the federal government has the ability to print more money to make good on its debt while state and local governments have to find room in the budget. But now those highly-rated states could also be downgraded, in part because such a rating might be hard to justify if the federal government has lost its top-notch rating, says Valeri. States that are heavily dependent on federal funding are also vulnerable for a downgrade, analysts say. In the near term, such downgrades could mean price declines for municipal bonds, says Valeri. They would also mean higher borrowing costs for states and local governments, making them more vulnerable to budget deficits, layoffs and further downgrades.
That doesn't mean investors should flee the sector. Municipal bonds are still attractively valued relative to Treasurys, says Valeri. Advisers recommend sticking with essential service revenue bonds those that are backed by revenue from water, sewer, utilities and other basic services as opposed to state general obligation bonds, which are funded from the state's general coffers. Also to avoid: bonds funded by entertainment-based projects, such as stadiums, arenas and hotels, which are likely to suffer if consumers cut back on spending.
In the short term, if investors look for safety, corporate bonds of all kinds could underperform, says Valeri. But longer term, the performance of corporate bonds should depend less on the rating of the U.S. Treasury and more on the usual factors: the strength of the economy and the health of individual companies. If the economy stays weak and the market stays volatile, investors will probably start to question corporations' ability to pay off their debts; the opposite would help corporate bonds rally, says Valeri. Like stock investors, bond investors are increasingly skeptical about the federal government's ability to prop up the economy these days. "How much ammunition is left to fight another big downturn?" says Crouch. Nervous bond investors should steer clear of junk bonds and stick with high quality corporate bonds, says Valeri. Perhaps a company with a better credit rating than the U.S. government would fit the bill.