Last month, Fitch Ratings downgraded the country’s credit rating from AAA (the best rating) to AA+, citing rising U.S. deficits as a percentage of gross national product and the political standoffs in Washington that have reduced confidence in U.S. fiscal management.
Inside the ratings
Bonds are debt instruments that larger companies sell to raise long-term funds. The buyers of bonds (bondholders) essentially loan the issuer of the bonds cash in exchange for regular interest payments until the loan is repaid on or before the specified maturity date. The annual interest rate (often called the coupon rate) is the guaranteed percentage of face value that the company will pay to the bond owner every year. The bond itself is a certificate that represents the company’s debt to the bondholder.
Bonds are issued by a wide variety of entities, including companies or governments. When they are issued, investors rely on Fitch Ratings, Moody’s, and Standard & Poor’s (S&P), the Big Three rating agencies. Ratings help investors decide how safe the debt is. Bonds with high ratings (such as AAA and AA+) are less likely to default than bonds with low ratings (such as BB and CCC). Highly rated bonds are typically safer but pay lower rates. On the flip side, high-yield bonds, or junk bonds as they are popularly known, offer relatively high rates of interest because they have higher inherent risks.
We’ve been here before
The downgrade of the country’s credit rating does not mean the United States is going to default. In fact, this is not the first time the country’s credit rating has been downgraded. It happened just over a decade ago in 2011 with S&P which also cited political standoffs in Washington related to the debt ceiling. The move was controversial, and the reaction was strong with the S&P 500 stock index falling by nearly 7 percent.
This time around, however, the reaction in the markets has been much more mellow. Fitch’s downgrade simply dropped the rating to match the S&P’s rating, which was never returned to a AAA. Many of the issues raised by S&P 12 years ago still exist today, and some have gotten worse. Many financial experts, including Warren Buffet of Berkshire Hathaway, say this downgrade is nothing to worry about.
What this means for you
U.S. markets dipped slightly following Fitch’s downgrade, but stocks have more or less recovered. The side effects most likely will not have much impact on the average person. Since U.S. Treasury bills and bonds set a base rate for all debt securities, any increase in interest rates on U.S. government debt due to increased risk would also raise rates on other forms of borrowing. So far, there has been no discernable increase in rates due to the credit downgrade. Interestingly, some companies such as Microsoft and Johnson & Johnson now have a higher credit rating than the United States, possibly making their bonds more appealing to investors than government bonds.
The U.S. rating, from both S&P and Fitch, could return to AAA, but that is unlikely to occur until the country shrinks its deficit and the near-constant political struggles abate.
In the Classroom
This article can be used to discuss financial management (Chapter 16: Financial Management and Securities Markets).
What are bonds and how are they rated?
Why is the market reaction to the downgrade less severe than last time?
What are the implications of the U.S. credit rating downgrade?
This article was developed with the support of Kelsey Reddick for and under the direction of O.C. Ferrell, Linda Ferrell, and Geoff Hirt.
Greg Ip, "Why Fitch’s Downgrade Matters," The Wall Street Journal, August 9, 2023, https://www.wsj.com/articles/fitch-downgrade-us-credit-rating-4ad98230
Katherine Greifeld, "The Weekly Fix: No Country Has ‘God-Given' Right To AAA Rating," Bloomberg, August 4, 2023, https://www.bloomberg.com/news/newsletters/2023-08-04/the-weekly-fix-no-country-has-god-given-right-to-aaa-rating
Ryan Ermey, "What This Week’s U.S. Credit Rating Downgrade Means for Your Money," CNBC, August 3, 2023, https://www.cnbc.com/2023/08/03/what-us-credit-rating-downgrade-means-for-your-money.html