What the U.S. Debt Downgrade Means to Bond Investors

Standard & Poor's downgrade of long-term Treasury debt to AA+ is an embarrassment to the United States and the latest challenge to our economy's reputation for resilience. However, bond investors shouldn't get into a tizzy over the rating agency's move. Putting aside the extraordinary jump in Treasury bond prices on August 8 (and the concurrent drop in yields), a result of flight-to-quality buying by panicked investors, you shouldn't expect major moves in bond prices and yields in the coming weeks and months. S&P threw its weight around, but it did not consign Treasury bonds to the garbage pile or question the bedrock principle that the U.S. backs its bonds with the full faith and credit of our government.

The downgrade is not a warning that the U.S. Treasury won’t be able to pay its bills or that it will have trouble borrowing money. An AA+ rating shows a “very strong capacity to meet financial commitments,” while AAA is “extremely strong,” according to S&P. (Aa1 would be Moody’s equivalent if it were to follow in S&P’s footsteps; Fitch, the third major rater, uses a scale similar to S&P’s.) More to the point, the Treasury, in partnership with the Federal Reserve, can create dollars or borrow from the rest of the world in U.S. currency. Swiss, German and Canadian bonds are having a wonderful run, but there aren’t enough of these or any other triple-A-rated income alternatives to soak up all the money in search of safe, liquid income investments.

The rating cut comes at a time when Treasury bonds aren’t especially appealing to individual investors. Savers have been disenchanted with Treasuries since the end of the 2008-09 financial crisis because of persistently low yields. They are joined by financial planners and advisers, who still consider Treasuries, even with an AA+ rating, to be the globe’s best repository for reserves of governments, banks and insurance companies, but a poor place for you and me to find income.

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Bonnie Baha, co-director of credit research for the DoubleLine mutual funds, decided weeks ago that a downgrade of the Treasury’s rating was coming and deserved. But that doesn’t mean she thinks Treasury yields will rise high enough, or even at all, to make government bonds competitive income investments, especially with the threat of a new recession looming. Baha thinks current, though depressed, T-bond yields already reflect the government’s diminished credit standing.

My advice: If you own scattered Treasuries or built a ladder of government bonds years earlier, don’t sell any of them. Just do not buy new Treasury bonds as older ones mature. That’s not because of the credit downgrade. It’s because you can get paid more elsewhere.

Treasuries are still suitable for part of an emergency reserve that assigns a higher priority to safety than to yield, says Connie Stone, of Stepping Stone Financial, in Chagrin Falls, Ohio. But for serious income, advisers nowadays prefer corporate and municipal debt. In both categories, it’s best to concentrate on investment-grade quality bonds, which means those rated BBB or better. Junk bonds got hammered far worse than investment-grade bonds on August 8, the first trading day after S&P announced its downgrade, and will continue to perform poorly if the economy falls back into recession. For instance, SPDR Barclays Capital High Yield (symbol JNK), an exchange-traded fund that tracks an index of junk bonds, sank 4.3% that day.

For those investing in tax-deferred accounts, Stone recommends funds that invest mainly in high-grade bonds. Dodge & Cox Income (DODIX) and Harbor Bond (HABDX), both members of the Kiplinger 25, fit the bill. The former invests mainly in corporate bonds and yields 4.4%; the latter is a clone of Pimco Total Return (PTTRX), the world’s largest bond fund. For high-bracket folks investing in taxable accounts, she suggests municipal bonds backed by essential-service revenues, such as those from water and sewer services. You can find municipals maturing in ten years that are rated AA+ and paying 2.8% to 3.3%, tax-free. A 3.0% tax-free yield is the equivalent of a taxable 4.6% for an investor in the 35% federal tax bracket.