When I first read about the rating agency Fitch recently placing all outstanding U.S. sovereign debt securities on Rating Watch Negative (RWN), I couldn’t help but spend some time thinking about why exactly the U.S. still carries a ‘AAA’ rating. Both Fitch and Moody’s still rate the sovereign debt of the United States triple-A (AAA/Aaa respectively). Naturally, there are those who, without giving any thought to the issue, would say it’s a no brainer that U.S. debt should carry a rating lower than triple-A. And there are certainly those who would quickly retort that because U.S. debt is denominated in dollars and because the U.S. can print dollars, a default is out of the question. Hence, a triple-A rating is deserved. What’s my take? I think S&P, which currently rates U.S. sovereign debt ‘AA+’, is more correct than Fitch or Moody’s.
Why is a rating of less than triple-A appropriate?
There are two reasons I think Moody’s and Fitch are incorrect to rate United States debt triple-A. First, the fact that a debt ceiling exists in the United States means that investors must worry about the possibility of a future default. Of course, should the debt ceiling ever be breached, there are those who will dismiss default worries by discussing prioritizing payments so as to ensure interest on the debt is paid. But, as has been the case for the past few years, that way of thinking completely ignores the greater risk of default that comes from rollover risk associated with Treasuries.
As we saw in the most recent debt ceiling debate, some very large institutions decided to sell the Treasury bills they owned with upcoming maturities, rolling the debt into slightly longer-dated bills. I suspect that will once again occur in a future debt ceiling debate. Depending on which entity is purchasing that debt, an institution or country that wanted to cause grave fiscal harm to the United States could easily do so by demanding repayment of principal, something the United States could not afford to pay with incoming revenues.
Without a debt ceiling, there is more of a case to be made that United States sovereign debt should carry a triple-A rating. With a debt ceiling, the possibility of a default becomes more real to a great enough extent that I don’t think a triple-A rating is warranted. I am not necessarily arguing that the debt ceiling should be eliminated. I understand why it exists, and there is merit to that line of thought. No debt ceiling would raise the risk of future out of control spending. But the more polarizing the environment becomes in Washington, D.C., the greater the risk that one day, the right (or wrong depending on your perspective) mix of Congressional members will be in power and will not come to an agreement on raising the debt ceiling. In recent years, that appears to be a more realistic possibility with each passing election cycle.
Second, rating agencies should consider whether nations with central banks that actively work to maintain negative real rates on sovereign debt aren’t technically defaulting on their debt. Intentionally creating a negative real rate environment is something the Fed appears to be doing. For that reason, I think it is justified to question whether a triple-A rating for U.S. sovereign debt is warranted. Of course, negative real rates of return aren’t an example of actually not paying back the fixed dollar amount in question. But rating agencies should consider whether sovereign nations actively seeking negative real rates of return deserve the highest credit rating available.
The recent debt ceiling debate once again illustrated the intense dysfunction among elected leaders in Washington, D.C. It is a sad state of affairs and one that will cause certain global investors to reevaluate their commitment to owning and purchasing U.S. debt as well as their commitment to the U.S. dollar. Because of the unique role that Treasuries play in the international financial system, I do not think major changes will come quickly as a result of episodes like we’ve recently seen in Washington. But as those in power continually create enhanced periods of uncertainty, investors world-wide will slowly lose confidence in the future assumed stability and dependability of the U.S. dollar and U.S. sovereign debt. The Federal Reserve and the Legislative and Executive branches of the U.S. government should not lose sight of this.
Despite the United States being a rich and powerful nation (rich even with the massive debt load), the mere existence of the debt ceiling combined with legislative and executive branches that seem more focused on gaining political victories than anything else is enough to warrant less than a triple-A debt rating. At the same time, because of the propensity for elected officials to allow extremely large deficits to be run for extended periods of time, the debt ceiling does provide a type of “check and balance” to the potential for out-of-control spending. Nevertheless, from a credit perspective, while it might help to control spending over the long run, the existence of a debt ceiling definitely enhances default risk whenever it is approached. Add to that the intentional policy of the nation’s central bank trying to create negative real rates of return for short- to intermediate-term benchmark Treasuries, and the case for a rating that is lower than triple-A becomes clearer from a fixed income investor’s perspective.
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