What a Ratings Downgrade Would Mean for Investors

Is it possible that the very place investors would rush to if the U.S. government was downgraded by a major ratings agency would be ... the U.S. government? It may sound counterintuitive, but if an influential ratings agency like Standard & Poor's were to actually downgrade the U.S. government, experts say investors would seek safety, probably in the form of U.S. treasuries, long known as one of the safest places for investors to park their money.

"Investors rate investment possibilities on a curve ... so while treasuries may not look good, as long as it looks better than the rest, even a downgrade doesn't necessarily mean, in the short run, a flight away from treasuries," says Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University in Fairfax, Va. The United States has its fair share of problems, de Rugy says, but other European countries, most notably nearly bankrupt Greece, are much worse off at the moment.

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No other bond market in the world is as large, liquid, and transparent as the U.S. treasury market, even if the U.S. government's credit rating is downgraded, says Jan Randolph, director of sovereign risk at forecasting firm IHS Global Insight based in Englewood, Colo. And because of that status, nothing catastrophic is expected to happen if the United States is downgraded one level from AAA to AA+. "A single notch downgrade may not necessarily have a big material impact," Randolph says. "America would still be able to issue debt, command reserve currency status, and have low interest rates, although you might expect those to go up a little." Generally, when a bond of any type is downgraded, the yields on it move higher because the ratings agencies are essentially assigning more risk to it. But treasuries are unique because they're still the traditional safe haven that investors choose in times of market turmoil.

Following a downgrade, Ray Humphrey, senior vice president at Hartford Investment Management Company in Hartford, Conn., says he would expect volatility to pick up in the stock market, but only for a few days. "It's going to be a bump in the road," Humphrey says.

In terms of safe alternatives to treasuries, experts say there aren't many. What comes to mind first are other high-quality bonds that carry top-notch ratings. "We've actually thought that high-quality sovereign debt such as Canadian sovereigns or German bunds would be a nice place to hide in better-quality sovereigns," Humphrey says. Both those countries also garner top-notch ratings from the ratings agencies. However, depending on how big the fallout is in the stock market, treasuries may still be the best opportunity. "You would expect that those two markets would do at least marginally better in the scenario that the U.S. is downgraded by one notch, but if equities really start to tank, I suspect the U.S. is probably going to be the safe haven place to be," Humphrey says.

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In addition, real assets like precious metals also stand to benefit from more uncertainty surrounding currencies. Investors generally flock to precious metals like gold in times of crisis because it's seen as a type of alternative currency. An ounce of gold now trades near record highs of around $1,600. While investors have been "rather wishy washy about their views on equities" over the last two weeks, flows into commodities and precious metals funds have been fairly consistent, says Lipper Senior Analyst Jeff Tjornehoj. In the last two weeks ending July 20, investors have injected more than $800 million into commodities precious metals funds, according to Lipper.

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Further down the road, Humphrey says his biggest concern is a spike in interest rates. While investors may flock to treasuries in the near term, if nothing is done about the ballooning budget deficit, he says the country's credit rating could continue to erode, which would result in higher interest rates. This is worrisome because treasury rates are one of the benchmark rates in the bond market. A number of rates, including mortgage rates, are tied to the benchmark treasury yield. "If all of a sudden our credit metrics start to move a little bit further south ... you could start to see the cost of financing on mortgages start to get very prohibitive for the average family," he says. That could spell trouble for an already weak housing market.

What's more, the U.S. government doesn't really control its own destiny when it comes to the treasury market. "Half the U.S. treasury market is held by foreigners now, principally Asian [countries] ... and how they see things is increasingly important," Randolph says. The Chinese government alone holds more than $1 trillion worth of treasury securities. If countries like China were ever able to find another place to invest their money, that's when investors should really begin to worry about higher interest rates.

Twitter: @benbaden

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