What S&P’s Opinion on the Credit Rating of the U.S. Government Means to You.

Yesterday, credit rating agency Standard and Poor’s fired a warning shot across the bow of the United States Government by changing its credit rating outlook to negative from stable. This means that there is a one in three chance that they would be forced to lower the U.S. Governments credit rating from the current AAA. S&P stated that the action was taken to reflect concern that congressional budget negotiations to reduce U.S. spending had bogged down and that an agreement could be difficult to reach or take too long to be effective. Oddly, the other major credit rating agency, Moody’s announced on the same day that it was reaffirming the U.S. Government’s AAA rating with a stable outlook, stating that they believed that the proposals now circulating around congress can succeed in bringing the budget deficit under control.

As an investor you should be concerned, because a downgrade of the credit quality of U.S. Treasury bonds, notes, bills and other obligations would extend to everything the government now backs, which includes the vast majority of the mortgages now outstanding in the U.S. and the FDIC. A downgrade would tighten credit and raise borrowing rates throughout the economy, not just for the government. This could slow the economy and nip our nascent recovery in the bud. In addition, if you own existing bonds of any kind, the value of those bonds would decrease as market interest rates rise. Note that this is not a problem if bonds are held to maturity but can be somewhat disconcerting when looking at your statement. It is also a problem in bond mutual funds where the manager may be forced to sell at lower prices due to redemptions.

While I’m concerned at the possibility of a downgrade, I take everything that comes out of the major credit rating agencies with a grain of salt these days. It’s worthwhile to keep in mind that these are the same folks who once rated virtually all mortgage backed securities AAA. Ever since the financial crisis (when we all found out that many were anything but) S&P and Moody’s have been falling all over one another trying to prove that they can actually get out in front of something. In this case I believe that S&P is overcompensating. The U.S. has a long history of doing what needs to be done… eventually. Our country also possesses an invaluable mature infrastructure and the world’s largest hoard of gold. ($387 Billion at last count). Hopefully S&P’s warning shot will wake up some folks in Washington and we can get our fiscal house in order sooner rather than later.

While I view a downgrade of U.S. sovereign debt improbable, it may be prudent to take steps to protect your portfolio from rising rates. Note that the specter of rising inflation would produce the same result and is more likely. We have been taking these precautions in our managed accounts at Pilot Capital. They include shortening maturities, reviewing the positioning of bond fund managers and considering some alternative (to bonds) income producing asset classes.