When does AA+ = F?

I’m not going to add to the litany of voices predicting how much interest rates will rise in the  days and weeks following the the US downgrade.  Nor am I going to write about whether or not S&P was justified in downgrading the US (I think they were).  But I am going to write about a more insidious issue resulting from this downgrade: the fact that AA+ is simply not good enough to pass many funds’ investment governance requirements.

Many different institutions – from Mutual Funds to Pension Funds to Money Market Funds (and even some Hedge Funds) – publish guidelines and restrictions on what types of securities can be held in the portfolio.  The US government’s various authorities limit what kinds of investments can be made by different types of funds – for example, mutual funds have to go through a detailed process to check their concentration limits in a number of different ways.  One of the most common ways for an investment fund to project safety, high quality and an image of low-risk is to limit fixed income investments to ‘AAA’ credit rated securities.  Even if they allow lower rated securities into their portfolio, they often limit their exposure to fractions of what is permitted for AAA bonds.

What’s going to happen when the investment committees and boards of directors meet this week?  One (or more) of several unappealing choices will have to be made:

  • The fund may decide that it does, indeed, need to sell all of its US Treasuries.  This would initiate a tremendous sell-off in US Treasuries.  Oddly, we’ve seen exactly the opposite – as of late Monday afternoon, the yield on the 10-year note is down 0.3%.  It seems the market demand for US Treasuries is immune to this credit downgrade.
  • The fund may decide that US Treasuries are still rated AAA ‘on average’ since two of the three major credit rating agencies did not downgrade the US.  Plenty of pundits disagree with the S&P’s decision to downgrade the US.  It’s not clear what happens if S&P further downgrades the US to AA sometime in the future, but for now it’s only one of three credit agencies to have downgraded the US at all.
  • The fund may decide to amend its bylaws / investment guidelines to invest in “AAA rated securities or US Treasury bills.  By adding the ‘or’ clause, this approach in effect defangs the credit agencies.  Of the three, I think this is the most likely, although it certainly carries risk.  While it’s rarely safe for a board of directors to modify their policies & procedures to accommodate a single incident, I think most people will agree that this is a very special case.

Only time will tell whether this downgrade really matters for funds that are required to hold AAA paper.  After a modest loss in Asian and European markets, the US market has reacted rather strongly Monday to the downgrade:  the S&P 500 was off 6.66%.

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