Treasurers might need to rethink their investment policies if the worst happens on August 2nd and a US debt crisis prompts a downgrade of the world’s ‘risk free’ investment destination.
An actual default is highly unlikely, even if the $14.2 trillion debt ceiling is not moved – the US might run out of cash to pay wages or healthcare, for example, but interest payments are likely to be prioritised.
In any case, “it is not really clear what the rating of a sovereign that prints its own money and has an independent monetary policy – such as the US – really means,” says DB Advisors’ Chief Economist Josh Feinman. “A country like that can always choose to inflate away its debt, depreciate its currency, rather than default.”
That might have a range of negative consequences, but it is not the technical default that ratings agencies look for, and does not put investments in US Treasuries in the same category as Greek government bonds or corporate bonds. Investors in those know there is a chance of a genuine default and they may not receive all, or even any, of their investment back.
The corporate debt issuance market, too, is unlikely to be affected. DB Advisors believes only municipal bodies in the US and those like Fannie Mae and Freddie Mac, which are supported directly by the federal government, will see their ratings fall. Moody’s, for example, has placed around 7,000 such bodies on downgrade watch, which would see ratings fall in lock-step with the federal government. “There are a small number of banks [in the US] that could potentially be subject to minor downgrades, and insurance companies, but after that there is no direct link [to corporate bonds] that we can see,” according to DB Advisors’ US CIO Steve Johnson.
There are still potential negative consequences for treasurers, though.
If the debt ceiling is not raised, there is still a very good chance of a downgrade – S&P estimates the chance of that happening is approximately 50:50.
Since many treasury investment policies – and those of the money market funds in which many corporates hold their short-term cash – rely on credit ratings, this could have a more serious impact, or at the very least prove a nuisance for corporates.
For example, corporates which only invest in AAA instruments will have to reassess their positions. They may feel there is still no chance of a US default if its rating slips to AA – the country can still borrow at exceptionally low rates, showing there is no real concern in the markets – and so simply amend their policies to make an exception for US Treasuries. Certainly it is not expected that the relative sense of risk around US Treasuries will change, perhaps making it unnecessary to avoid investing in them.
The more risk averse treasurers are avoiding US Treasuries with maturities close to the 2nd August, though. According to a recent survey by the Association of Finance Professionals, 20% of corporates have reduced their holdings of the securities. The majority, however, said they intend to take ‘at least one defensive action’ if an arrangement is not reached to raise the debt ceiling. Eight per cent of those questioned will liquidate all US Treasury holdings; 16% intend to shed some but not all; and 28% would not buy more, but just maintain current holdings. Just over half also expect to see the cost of debt financing, bank credit and other fund raising increase, too.
One treasurer, who asked to remain anonymous, told Treasury Today: “If a downgrade does happen, we have an action plan in place. The focus is on interest rates – we want to hedge those risks and FX risks against any reaction on the markets.”
Money market funds, in which many corporates invest, may have to reassess either policies or portfolios. Investing in high-quality, liquid assets, US Treasuries are a popular choice. “Most portfolios have average credit quality constraints that perhaps would be violated if the agencies downgraded the US to below AAA level,” says Johnson, prompting “a discussion between the portfolio manager and clients on revising policy statements. This is really a nuisance but not unmanageable.”
Alternatively, the funds would have to sell lower-quality paper and bonds to maintain their higher average standards. At a time when returns are very low – Crane Data’s 100 Money Fund Index puts returns at 0.03% – selling the lower-rated higher-yielding assets may be an unpopular move with investors.
David Stebbings, PwC’s Director, Treasury Advisory, thinks there is no real need to worry, though: “US Treasuries are still the world’s safe haven. There is nowhere safer for USD – what is the alternative?”
In summary, the sky won’t fall in on corporates if a debt ceiling agreement is not reached in time – but it will prompt an unnecessary reassessment of investment policies, and could hit returns.