Possible Effects of a U.S. Credit Rating Downgrade

By Ryan Snefsky

The other day, a good friend of mine asked what I think would happen if there was a downgrade to the credit rating of the United States. In order to really understand the effects, we first have to look at two key pieces of background information.

Key facts influencing the effects of a downgrade

1) The majority of the world’s major investors view our bonds as the safest in the world.

2) When comparing interest rates among different entities, you get a higher yield (or effectively higher annual interest payment) when you purchase bonds that have higher levels of default risk. It's the basic concept of risk and reward. You should have a higher potential for profit for assuming a higher potential for loss.

Effects of a downgrade

If the U.S. receives a downgrade in its credit rating, that implies that U.S. bonds are now perceived to be more risky than they have been in the past. And if we outright default, it's quite obvious that they are substantially more risky than before.

When bonds are perceived as being more risky, investors demand a higher rate of interest for assuming a higher level of risk. At the point of a downgrade, our bonds will immediately be worth less on the market because bond prices and interest rates move in an inverse manner.

However, because the U.S. is perceived to be the safest in the world, it then stands to reason that the bonds of every other entity in the world should now be considered to be at least a little more risky than before downgrade.

Meaning, if the market was previously handicapping another government’s bonds by a difference of +0.5% compared to our bonds and our bonds adjust their interest rates upward, then it stands to reason that the interest rates of the other government’s bonds will be adjusted along with the U.S. to maintain the original 0.5% interest rate difference.

Because U.S. Government debt is considered to be the safest, a credit downgrade will cause what is known as a global re-pricing of risk, where interest rates worldwide will go up.

If U.S. bonds were not considered the safest in the world, but instead maybe a medium level of safety and received a downgrade, then every other entity with bonds that were previously considered riskier than the U.S. would see a rise in their interest rates. However, any entity with bonds that were previously considered to be safer than the U.S. would not see an increase in interest rates.

Think of it like a ladder. If you're standing on the top rung, it's the riskiest place to be. If you saw off the top rung, the person standing on that rung is going to fall off, but anyone down below is still safe. But if you saw off the bottom rung, which is the safest rung, then anyone else that was standing on a higher riskier rung takes a hit too. This is why key fact #1 above is so important.

In addition to bonds, stock prices would be negatively affected.

The equation used to estimate what a stock's true value is, regardless of what the market is currently paying, uses what is known as the "risk-free rate." Worldwide, analysts use U.S. treasury bonds as the determining value of the risk-free rate because of the perception of safety.

I won't go into the entire equation here because it is a little too complicated for the scope of this post. But as far as the risk-free rate applies to the equation, stock prices tend to go higher as the risk-free rate goes lower and vice versa.

A downgrade to the credit rating would not only make U.S. stocks worth less, but it would have a similar effect with stocks around the world.

If countries like Greece, Spain, Italy, Portugal, and Ireland (which are having extreme difficulties paying their interest payments at current interest rate levels) experience even higher interest rates, their likelihood of defaulting goes up substantially.

Couple that with a fact (little known to the general public) that about 54% of the revenues of the U.S. companies that make up the S&P500 come from overseas. So if Europe's economies experience a contagion of difficulty, it drastically affects our companies here in the U.S.

Companies that are large enough to be included in the S&P500 are frequently included in the assets of 401(k)s, IRAs, and pension plans. A credit downgrade would likely have a negative impact on investors’ retirement accounts.

The U.S. will not necessarily default on its interest payments if a deal is not made by the August 2nd deadline.

As a final note, many in the media are saying that the U.S. will default on its interest payments if there is no deal on raising the debt ceiling by August 2nd. This is actually far from a certainty.

The truth of the matter is that the U.S. would be short of money for payments for some of its liabilities, but would still have enough money to pay its the interest payments and would likely pay them to avoid the global consequences. This would likely lead to a credit downgrade, but would not technically be a default.

If the U.S. didn't make entire payments for social security, medicare, military salaries, or any of the other things the media, as well as President Obama, say might not get paid if a deal is not reached, it would be very bad for the U.S. economy, but would not be as immediately damaging on a global level.