United States’ bond rating might be downgraded by credit-rating agencies

August 7, 2011

So much for enactment of a debt-ceiling hike smoothing the feathers of ruffled investors. America’s AAA credit rating is safe — at least for the next few months — but the markets are acting as if the threat of imminent default by the U.S. Treasury were still real.

For stocks to break out of their funk, you’ll need to see better news on jobs, industrial output, exports, retail sales and gross domestic product. Few economists and fewer stock-market strategists foresee much of that in the months ahead.

The outlook for bonds is more complicated. A downgrade of the United States’ bond rating by one or more of the credit-rating agencies remains a possibility. The issue is no longer the debt ceiling but the inability of our political system to rein in soaring budget deficits.

If the agencies do downgrade Treasury debt, panic selling of bonds isn’t likely to ensue. The fact is, there aren’t many alternatives that are as safe and liquid as Treasuries. Treasury debt accounts for 55 percent of the worldwide supply of AAA debt securities — that includes the IOUs of all foreign governments, plus corporate and municipal obligations. At a rating of
AA-plus, Treasuries would still be among the world’s highest-rated and most-liquid investments.

Interest rates on Treasury bonds would edge up — a good guess is about a quarter of a percentage point at first. If you own a mutual fund or exchange-traded fund that owns Treasuries, that would knock 2 to 3 percent off its value. But yields wouldn’t climb enough to make Treasuries particularly appealing for income investors.

Fortunately, other investments can provide decent income without much risk. Municipal and corporate bonds held their value through the debt fight and, as long as the economy doesn’t fall into a fresh recession, the principal and interest are secure. Many advisers are recommending munis, partly because their yields are high compared with Treasuries. However, you need to pick bonds carefully. Cuts in federal aid to states will hurt such issuers as hospitals, nursing homes and colleges. Stick with general-obligation bonds or bonds secured by essential services such as water, roads and sanitation services. Munis rated A or higher are fine; even issuers rated BBB, the lowest investment-grade ranking, rarely default.

The same is true with high-grade corporate bonds. Only four U.S. companies carry AAA ratings but, with profits still high and balance sheets strong, you should be okay with anything down to A. If you want to switch from a Treasury fund to a corporate bond fund or go-anywhere bond fund, such as Loomis Sayles Bond, go for it.

But get ready for more volatility in “junk” bonds and possibly in corporate debt rated BBB (the lowest investment-grade rating). One reason is that many pension funds and other institutions are required by their bylaws or their clients to keep an overall portfolio average rating of at least AA. If Treasuries are downgraded to that level, these investors will need to avoid or trim their holdings in lower-rated bonds to offset the government’s downgrade.

Foreign bonds and high-dividend foreign stocks remain an ideal diversifier for income and safety. Combining an emerging-markets bond fund with an international bond fund is a smart strategy.

Kosnett is a senior editor at Kiplinger’s Personal Finance.

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