We don’t often discuss recent financial news for the simple reason that, generally, very little is worthy of consideration by a real, long-term investor. Most of what is discussed in the financial press is of little or no value. However, when something that might impact you does happen, we want to you to understand it and invest accordingly. Late Friday (August 5, 2011), a potentially big event was splashed across the front page of publications worldwide. One of the 3 big securities ratings firms, Standard & Poors (S&P), reduced its rating of U.S. Treasury securities from the highest available, AAA, to AA+. This downgrade placed U.S. debt on the same apparent risk plane (at least in S&P’s opinion) as country’s like New Zealand and Belgium. S&P only accords a few countries their highest rating (Canada, Great Britain, etc) and, of those, none have anywhere near enough bonds floating about to meet the global demand for safe, sovereign debt.
So, what does this downgrade really mean for investors like you (non-speculators)? Let’s start by putting this event in perspective. We are talking about a single company’s opinion (and, don’t forget, this is the same company that rated garbage mortgage pools as AAA securities). The other big firms, among them Moody’s and Fitch, have maintain their equivalent of a “AAA” rating for U.S. government debt.
According to economist, Bill Conerly (who will be appearing on next week’s Investoradio), the three major ratings agencies, “...don’t have a secret formula. They do not have secret data. They do not have analysts with super powers.”
In other words, even though their opinion carries some weight with small investors, the major debt investors (large institutions, banks, funds, and other nations) will form their own opinions of securities based on their own analysis. In addition, Banking regulators and many mutual fund’s internal standards consider U.S. Treasury debt to be the highest quality security they can hold in their portfolios, no matter what the private ratings might be.
Assume for a moment that investors around the world suddenly agreed with S&P and no longer felt totally comfortable holding U.S. Treasury paper. Where would they put the $14 trillion currently invested in Treasuries? Author and Investoradio co-host, Larry Swedroe says that “...there is no good alternative. UK is next biggest government bond market but it is only about 1/6 of the US and they have the same debt to GDP ratio as we do.”
The combined national debt of every country on the planet is just over $40 trillion, and most of that is issued by countries with an S&P rating at or below that of the United States. If you are looking for a safe place to park several billion dollars (or trillion dollars, in the case of China), can you think of any better place to put it than the debt of the world’s largest economy (20% of global GDP) with the ability, if push came to shove, to tax the wealthiest population on earth (estimated U.S. household wealth is almost $60 trillion)?
The worst case scenarios bandied about would have the interest rate on long-term Treasury debt rising no more that 0.75%. “When Japan lost its AAA [rating], for example, there was almost no effect,” says Swedroe.
It is important to remember that, if you follow our investing suggestions, you should not own any long-term Treasury paper, only short to intermediate term debt that, generally, has very little volatility.
There certainly may be some shorter duration volatility in the stock markets, as people overreact to the constant drone of negativity from the popular press. If the future is anything like the past, any pessimism will be short-lived as investors realize that the world is not ending and that their options are limited. There could even be a silver lining to this dusky cloud. The ratings downgrade might just spur both Congress and the President to get serious about finding innovative ways to both reduce our national debt and get the economy moving forward again.
Events like this illustrate just how important the sensible, risk-based, low-fee, stable asset allocation strategy we espouse really is. Investors who have a proactive, globally-diversified equity portfolio fortified with a sizable portion of shorter term Treasuries have fewer reasons to panic and overreact to the occasional bad news. Plus, should stock prices remain low, you will automatically be moving some money from Treasuries into stocks “on sale” when you rebalance.
Finally, economist Conerly states, “What matters for the Treasury [investors] is the fundamentals, not the ratings. The fundamentals aren’t as great as they used to be, but neither are they so bad that anyone expects to lose money buying a Treasury bond.”