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Lower Bond Rating? Buyers Binge

Matthew A. Winkler is a Bloomberg View columnist. He is the editor-in-chief emeritus of Bloomberg News.
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It's been four years since the U.S. government's credit rating was downgraded by Standard & Poor's after members of Congress threatened to put the world's biggest economy on the brink of default because of federal spending they opposed.

Now there's another threat of government paralysis, this time largely over opposition to financing Planned Parenthood. There are many things to fear about the politics of brinksmanship, but the effect of another rating downgrade is not one of them.

QuickTake Rating the Raters

After being downgraded on Aug. 5, 2011, U.S. debt got more valuable. Instead of driving investors away and forcing up interest rates, as downgrades are supposed to do, investors treated the downgrade as a buying opportunity. Treasury bond prices rallied and interest rates fell immediately. The government's cost of borrowing declined 0.14 percentage point during the ensuing 200 days, according to a Bloomberg index of Treasuries. For investors who still hold Treasuries they bought when they were downgraded, the total return has been a respectable 11 percent, according to data compiled by Bloomberg.

It's not just a U.S. thing. Over the last four years, global investors have made a mockery of rating downgrades aimed at Austria, France, Japan, New Zealand and, more recently, Finland and Greece. In every one of those cases, bond prices rose and interest rates declined during the 200 days following the downgrade, according to data compiled by Bloomberg.

It's true that stocks tumbled in 2011 after Standard & Poor's said the U.S. deserved the less creditworthy AA+ grade instead of AAA. Shares worldwide lost more than $6 trillion in less than a month. 

The bond rally, however, took off and kept going. When the Treasury sold $29 billion of seven-year notes in May of 2012, nine months after the downgrade, their value was never higher as they provided a record-low interest rate of 1.2 percent. The yield on the benchmark 10-year Treasury bond still is less today, at 2.14 percent, than the 2.25 percent quoted on August 5, 2011.

The U.S. fiscal situation, meanwhile, has improved steadily even though Standard & Poor's justified its downgrade by insisting the outlook was deteriorating. The budget deficit as a percentage of gross domestic product declined to 7.7 percent from 7.9 percent in the 200 days after the downgrade. Today, the deficit is only 2.4 percent of GDP and forecast to shrink even more as the economy enters its sixth year of expansion and the Federal Reserve prepares to raise interest rates for the first time since 2006.

There isn't a developed country's debt that hasn't proved profitable for investors who saw downgrades as buying opportunities. When Austria was lowered to AA+ on Jan. 13, 2012, the total return for the next 200 days was 9.2 percent. For New Zealand, the return was 3.7 percent during the 200 days after its September 2011 downgrade. More recently, Finland returned 5.2 percent in the 200 days after its October 2014 downgrade. This year, Greece returned 7.9 percent since the February downgrade, according to data compiled by Bloomberg. 

Sovereign debt ratings often prove to be contrary indicators. Look at Germany and France. Germany has maintained the highest possible rating, AAA. France was downgraded in 2012. Yet it was France that provided investors with the better return, 8 percent, almost double the 4.2 percent returned for Germany's bondholders.

Similarly, when comparing Germany to the U.S. during the 200-day period following the U.S. downgrade, Treasuries provided a total return of 2.8 percent while holders of German bonds lost 2.4 percent measured in U.S. dollars, according to Bloomberg data. Bondholders of AAA-rated Euro government debt did even worse, losing 3 percent, measured in dollars.

When comparing all downgraded sovereign bonds to AAA sovereigns in U.S. dollars, the downgraded bonds outperformed the top-rated debt.

The fallacy of using sovereign debt ratings as a guide to investing was revealed in a June 19, 2012 Bloomberg news report examining 314 upgrades, downgrades and outlook changes during the past 38 years. For almost half of these decisions, government bond yields fell when a rating change suggested they should climb, or they increased when the change signaled a decline. Interest rates moved in the opposite direction implied by the rating 47 percent of the time for Standard & Poor's and Moody's, the two companies that dominate sovereign ratings (the data measured yields after a month, using U.S. debt as a global benchmark).

In other words, if you want to make the correct decision based on the latest sovereign rating, you could do worse than ignoring it and flipping a coin instead. 

(With assistance from Shin Pei)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matthew Winkler at mwinkler@bloomberg.net

To contact the editor responsible for this story:
Jonathan Landman at jlandman4@bloomberg.net