Do Sovereign Downgrades Matter?

Speculation continues to build that another major credit rating agency will downgrade the US this year. What impact, if any, would further sovereign downgrades have on the capital markets?

Larry Swedroe wrote an interesting article last week for CBS on the possible impact on stock markets that a much-rumored potential downgrade of theUS by another major credit rating agency would have. We recently researched the possible impact on bond markets by studying previous downgrades of sovereign debt.

As explained more fully in When ‘Risk-Free’ Isn’t Risk Free: The Impact of a Treasury Downgrade by my colleague Ivan Rudolph-Shabinsky, we found that over the past two decades, yield spreads have typically changed very modestly when highly rated countries are downgraded. In fact, for countries downgraded a single notch to AA+ from AAA, the average spread barely changed at all in the months after the downgrade, as shown at the left side of the Display.

Downgrades: Usually Little Impact on High-Quality Sovereign Spreads

Put simply, a downgrade from AAA to AA or even to A usually doesn’t rattle investors enough to make them question a government’s commitment to meeting its obligations. Markets mostly shrugged off the downgrades of Canada in 1994 and 1995; New Zealand, Finland, Italy, Belgium and Ireland in 1998; and Japan in 2000, 2001, 2002 and 2009.

Unsurprisingly, our research also found that the lower the new rating, the greater the market reaction. Downgrades into the BBB category or lower (the cusp of investment grade) generally led to significantly higher financing costs.

Furthermore, as recent events in Europe suggest, when downgrades take place in the context of a broader economic or financial crisis, yields can rise significantly. This has been seen time and time again, from Italy’s 1991 downgrade in the midst of recession to Iceland’s in 2006, and from Spain and Ireland’s downgrades in 2009 to Spain’s next downgrade in 2010. In each of these cases, the downgrades compounded concerns that were already curbing market appetite for the bonds.

Of course, the situation in Europe today differs in one key respect from many prior instances of sovereign downgrades in developed countries. Euro-area countries today are issuing debt in euros, which is technically more akin to a foreign than a domestic currency. These countries do not have their own central banks and, therefore, do not have the ability to simply print money in their local currency in order to pay back debt.

So, let’s go back to our original question. What would the impact on Treasury yields be if the US were downgraded from AAA to AA+? Our analysis suggests it would be limited, especially given the US’s long-standing status as a safe haven in times of crisis. That status is unlikely to change anytime soon, as I argued in a recent post.

To be sure, given the sheer size and presence of the US market, a sovereign downgrade could provoke a bout of risk aversion across the capital markets, pushing up yields on risk assets globally. But if the market perceives that the US government’s willingness to pay its claims is unchanged, the new bout of risk aversion could even spark safe-haven flows into US Treasuries, supporting prices and lowering yields. In fact, Treasury yields crashed to record lows in 2011, despite the actual downgrade by S&P last summer and threats of additional downgrades.

Of course, European countries like Spain, Ireland and Italy do not have the luxury afforded by safe-haven status. They are under severe pressure to get their fiscal houses in order. But even in the US, government inaction could lead markets to doubt policymakers’ ability to address long-term budgetary issues. In that case, expectations that the only way out of the debt burden is for policymakers to stimulate inflation—perhaps by printing money—could begin to drive up yields. (Inflation is a possible solution because it is much easier to repay debt incurred over many years with less-valuable dollars.) In this scenario, the US could fall into the category of sovereign downgrades that accelerate an already-worsening fiscal situation.

The rating agencies are considering downgrading the US because its debt and deficit numbers are troubling. However, judging from the historically low level of US Treasury yields today, we’re a long way from a crisis. Nonetheless, policymakers cannot afford to be complacent.

This post contains links to third-party websites. AllianceBernstein is not responsible for nor does it endorse the content on these sites.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AllianceBernstein portfolio management teams.

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein.

Douglas J. Peebles

Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer of AB Fixed Income. In this role, he supervises all of the Fixed Income portfolio-management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within the fixed-income division, having served as director of Global Fixed Income from 1997 to 2004, and then co-head of AllianceBernstein Fixed Income from 2004 until August 2008. He earned a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

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9 thoughts on “Profit from Your Premium Bonds

  1. Yes, but you give up a full coupon!

    I have many accounts with 15% muni profits, 5% coupons, and 8-10 year call protection. No one wants to give up such a coupon!
    Your idea!
    Thank you,
    Ira Miller, Morgan Stanley,, 585 987 6072

    • We like high coupons with 8 to 10 years in call protection as well, provided the bonds don’t have very long stated maturities. What concerns us about long-term bonds trading to their 8- to 10-year calls is that their value may fall hard when interest rates eventually rise. That is what we mean when we say that they could sell off like a long bond. A premium coupon bond with similar call dates and a shorter maturity offers similar potential return to the long-maturity bond when you consider income and roll, but has significantly less downside risk should interest rates rise.

  2. Good idea, but doesn”t apppear to take into account: (1) the tax aspect on selling the premium bond–15%-20% today–next year?? Clients love great ideas, but loathe the menion of taces–hence the broad appeal of tax free bonds in the first place. 2) The [often hidden] cost of selling the premium bond and buying the new [lower coupon] bond. Often the spreads on selling and buying smaller amounts make such changes financially impractical. And (3) Unless client has enough gain and selling sufficient quantity to buy additional bonds, what does he do with the “profit”? E.g. sells $15M bonds @ 115, gives client $17,250; either needs to add $2,500 to buy $20K, or, of course, invest it all in a mutual fund such as yours.

  3. Note sure if previous message was received. Suggestion does not appear to consider:
    (1) Capital gains tax on selling premium bond
    (2) Cost of transaction (spreads on selling/buying smaller quantities can be significant)
    (3) Unless client sells sufficient quantity to allow purchase of additional bonds, either needs to add money or, of course, buy a mutual fund (such as yours)

    • You are exactly right to consider all the costs associated with a trade, and that includes taxes and the bid/ask spread in the market. With respect to taxes, a number of clients still have loss carry-forwards that could shelter realized gains whether they are realized this year or next. If they don’t, the cost of realizing a long-term gain may be less this year than next, which encourages you to consider making the trade this year. Still, the tax cost and potential trading costs need to be included in the analysis. While long-term and intermediate-term bonds offer similar potential returns in a stable market today when both income and roll are taken into account, the investor has to determine how much they’d pay in taxes and trading costs for the reduced interest-rate risk of a intermediate-term bond. One way to reduce this cost would be to consider reinvesting a portion of the proceeds in a higher-income portfolio…but, that a topic for another post.

    • At this point, we don’t believe the Fed will end Operation Twist next month, as previously scheduled. But, Operation Twist will eventually end, which would reduce demand for long-term Treasury bonds. If long-term interest rates rise in response, as we’d expect, investors who sold their long-term bonds today will be comparatively better off.

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