What if the rating agencies downgrade U.S. Treasury bonds? Does that mean our government will have to pay higher interest rates? Perhaps not.
When a borrower’s fundamental ability to repay a debt deteriorates, it’s reasonable to expect a higher interest rate on the borrower’s debt. But what if the ability to repay deteriorates (as is the case with the United States), and then some time later a ratings agency downgrades the debt? That’s what we are afraid of regarding the United States government. To answer that question, we need to understand the role of ratings agencies.
The buyers of debt (portfolio managers of mutual funds, investment trusts, insurance companies, etc.) need to understand the risk of the bonds that they buy. They often outsource that analysis to ratings agencies. Many of the portfolio managers are capable to analyzing credit as well as the ratings agency analysts, but they don’t want to spend all of their time doing that. So for small holdings, they use ratings.
However, it’s a different story for large holdings. The investors are likely to pull the raw information about a borrower, roll up their sleeves, and analyze the credit quality themselves, either as a primary decision-making tool, or as a double-check on the rating. Here’s the key point: any analysis that a rating agency does could be done by any other investor. Moody’s and Standard and Poor’s and Fitch don’t have a secret formula. They do not have secret data. They do not have analysts with super powers. In the case of the United States Treasury, the ratings agencies don’t have any knowledge that a well-trained analyst cannot obtain.
Moody’s analysis of U.S. Treasury securities is headed by Steve Hess, whom I worked with at First Interstate Bank some years back. Steve is a good economist; I respect his ability. He is certainly one of the better economists who study sovereign debt risk, but he’s not so much better than the rest that everyone bows to his judgment and wonders in awe how he manages to be so astute.
If Moody’s downgrades the debt of, let’s say Conerlyville, Mississippi, that will push interest rates on the debt up. Nobody else is analyzing Conerlyville, because it’s such a small borrower, so investors take Moody’s word for it.
If Moody’s were to downgrade the United States of America, however, that would not push our interest rates by itself. All the large investors are already forming a judgment about the risk of the debt. They are not outsourcing that particular analysis to the ratings agencies.
What matters for the Treasury’s borrowing costs 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.