An unwelcome surprise.
Last week, Fitch Ratings startled markets by lowering the credit rating of United States Treasuries from AAA to AA+.1 It was the second rating agency to downgrade U.S. Treasuries; Standard & Poor’s cut its rating to AA+ in 2011, reported Benjamin Purvis and Simon Kennedy of Bloomberg.
The decision to lower the rating was not a comment on the strength of the U.S. economy, which expanded faster than expected in the second quarter on the strength of business investment in equipment, particularly transportation equipment, reported Erik Lundh of The Conference Board.2
While many were baffled by the decision, as well as its timing, Fitch had warned it was considering a rating downgrade in May when lawmakers were haggling over the debt ceiling while the possibility of default loomed, reported of Bloomberg.3
Last week, Fitch Senior Director Richard Francis told Davide Barbuscia of Reuters, “Fitch downgraded the U.S. credit rating due to fiscal concerns, a deterioration in U.S governance, as well as political polarization reflected partly by the Jan. 6 insurrection.”4
There are now 10 countries with government bonds that are rated AAA by at least two rating agencies: Germany, Denmark, Netherlands, Sweden, Norway, Switzerland, Luxembourg, Singapore, Australia and Canada, reported Tania Chen of Bloomberg.5
Markets did not take the downgrade well. Stocks sold off and Treasury rates rose mid-week.6 Jacob Sonenshine of Barron’s reported:
“Of course, the [stock] market always needs a reason to fall, and this past week it found one in surging Treasury yields. It’s hard to tell exactly what made them pop. Though some blamed Fitch’s downgrade of the U.S. credit rating to AA+ from AAA, it’s more likely a combination of massive issuance—the Treasury said it plans to issue more debt than had been expected—and solid economic data that forced market participants to reconsider their growth targets. Higher yields make stocks worth less, all else being equal.”7
Markets briefly reversed course later in the week when the U.S. employment report showed jobs growth easing. Overall, employment data supported the idea that a recession may be avoided. The number of new jobs created remained above the pre-pandemic monthly average, and average hourly earnings were up 4.4 percent year-over-year, according to Barron’s Megan Leonhardt.8
At the end of the week, major U.S. stock indices were lower, reported Barron’s.7 Yields on longer U.S. Treasuries rose more than yields on most shorter Treasuries, steepening the yield curve.9
WHAT ARE BONDS? Bonds are loans that investors make to governments, companies and other entities. When an investor buys a bond, they agree to lend their money for a specific period of time. In return, the issuer of the bond agrees to pay interest and return the investors’ principal when the bond matures.9
Bonds are a part of many investment portfolios because they:
- Offer a source of income, and
- Help manage overall portfolio risk.
Generally, bonds are thought to be safer than stocks; however, they are not risk-free. Bonds have interest rate risk, which means the value of a bond changes over time, depending on how attractive its interest rate is to investors. For example:
Bond values fall when rates rise. If interest rates move from 3 percent to 5 percent, and new investors will earn a 5 percent interest, then the value of bonds offering 3 percent are likely to drop. The opposite is also true.10
Bond values rise when rates fall. If interest rates move from 5 percent to 3 percent, and new investors will earn a 3 percent rate of interest, the value of older bonds offering a 5 percent return are likely to increase.10
The risk and reward profile of a specific bond depends on a variety of factors, including:
The length of time until the bond matures. When a bond “matures,” the issuer is expected to repay the money it borrowed. Maturities may range from one month to 30 years. Bonds with shorter maturities tend to pay less interest because the chance that interest rates will change significantly is lower.10
The creditworthiness of the borrower. Creditworthiness reflects whether the borrower is expected to pay interest and return principal in a timely way. Independent rating agencies – Fitch, Standard & Poor’s and Moody’s – review the financial and credit histories of governments and companies that are issuing bonds, and then assign ratings.11 There are two broad rating categories:
- Investment grade (AAA/highest quality, AA/high quality, A/strong quality and BBB/medium investment grade),12 and
- Below-investment grade (BB/low investment grade, B/highly speculative, CCC/substantial risk, CC/high probability of default, C/default in process and D in default).12
There are many nuances to bond investing. If you have questions, please get in touch.
Weekly Focus – Think About It
“There is nothing either good or bad but thinking makes it so.”13
—William Shakespeare, playwright