Is it time to abolish the triple-A rating?
It’s looking increasingly likely that the US is going to lose its triple-A credit rating at some point in the next 12 months or so, whatever happens to the debt ceiling. And right now, nobody knows what the consequences of that would be: it’s never happened before. Paul Krugman is trying to put a brave face on things and point out that hey, sovereign borrowing costs didn’t rise in Japan. (Not, of course, that turning out like Japan is exactly desirable.)
But the fact is that Japan never got much benefit from having a triple-A rating in the first place. Japan borrows overwhelmingly from its own citizens, who have lots of savings — they don’t give two hoots about what Moody’s thinks of their country’s creditworthiness.
The US, by contrast, is very different. Treasury bonds are the ultimate global asset class: they’re the epitome of risk-free safety for investors all over the world. Look at what happened when the subprime bubble burst and the US economy was plunged into the greatest recession in living memory, causing a plunge in tax revenues, a spike in unemployment, and a surge in government debt: Treasury prices went up. That’s what happens when you’re the risk-free asset of choice: you’re the beneficiary of the flight-to-quality trade whenever markets get spooked.
Which brings me to the question of what exactly a triple-A credit rating means and does. To fully understand this, it’s important to realize just how lazy and/or overworked institutional fixed-income investors are. A lot of their time is spent drumming up new investments, holding existing clients’ hands, and the like — and when they do get time to do real analysis, the first thing they worry about is always interest-rate risk. If you’re managing a bond portfolio, you’re obsessed with the duration of your portfolio, where your maturities are, and the like: you’re constantly putting on steepeners or flatteners or otherwise trying to manage what’s happening with interest rates in whatever currency you’re investing in.
Only once they’ve got the rates situation worked out do fixed-income investors start thinking and worrying about credit risk. Credit is an overlay — a way of boosting returns over and above what you’d get from rates alone. Sometimes you want more credit risk, sometimes you want less; when you want more, you buy lower-rated bonds with higher yields, and when you want less you buy higher-rated bonds with lower yields.
But the triple-A credit rating is not a credit rating like any of the others. It’s basically a sign saying “no credit risk here” — a way of investing in fixed-income assets without taking credit risk. Triple-A bonds are in this sense a pure interest-rate play — while they can rise or fall in value, and they can get illiquid at times, the idea is that they’ll never default.
In their heart of hearts, fixed-income investors know that there’s no such thing as no credit risk — especially in a world where more than half of the bonds being issued are rated triple-A. But that’s a worry for academics and people with time on their hands. If there’s credit risk in triple-A bonds, it’s too small to price or to worry about, and so, by convention, it’s ignored.
That’s how the financial crisis happened: enormous quantities of triple-A-rated nuclear waste was issued and placed with fixed-income investors who were looking for a modest yield pickup over Treasuries with no real risk of default. They outsourced their due diligence to the ratings agencies: after all, these structured products were highly complex, and precious few bond investors had the ability to even try to work out the credit risk in them on their own.
Nowadays, people are a bit warier when it comes to structured products. But the triple-A mystique remains, and amazingly continues to adhere to Treasuries even as the current debt ceiling debate brings us closer and closer to default. More importantly, it adheres to municipal bonds: individual investors — people who certainly have no ability to gauge credit risk — demand triple-A ratings precisely because they don’t want to have to worry about credit risk. Similarly, people are happy keeping their money in the bank because it’s insured by the FDIC, which in turn is backed by the full faith and credit of the US government. Triple-A.
So what happens if the US loses its triple-A? The simple answer is that nobody knows. But it will certainly cause second thoughts among people who up until now have been very good at ignoring the question of credit risk in triple-A assets.
The problem is that the world of finance is built on mass suspensions of disbelief. Money itself has value only because we as a society all opt to believe that it does. When we deposit money in the bank, we happily leave it there and believe that it’s available to us on demand, despite the fact that the bank has taken that money and lent it out to someone else. Similarly, we believe that our investments are worth whatever they’re changing hands for today, even though we’re not selling them today, and any state of the world where lots of people wanted to sell those investments is a state of the world where they’d likely be worth much less than they are now.
The single biggest beneficiary of this suspension of disbelief is the USA. Because everybody believes Treasury bonds to be risk-free, they’re a risk-off asset, and they tend to rise in value whenever the world starts looking scary. They’re the place you put your money when you’re not thinking — they’re the default option, the safe end of the barbell. No one buys Treasury bonds because they want to go long US credit risk: they buy Treasury bonds because they don’t want any credit risk at all, and because they want the most liquid instrument in the world.
If the US were to lose its triple-A rating, all that would change. Treasuries would remain highly liquid, simply by dint of the sheer quantity of the things that there is outstanding. And they would continue to be used as collateral in repo operations and the like, just because there’s no alternative. But their fundamental nature would change forever. Look, for instance, at all the investors who are standing on the sidelines right now, ready to jump in and buy Treasuries if they sell off sharply. That’s a speculative, risk-on move: you try to catch the falling knife, and then ride the rebound.
A downgrade probably wouldn’t cause an immediate selloff in Treasury bonds, not least because there’s no other asset in the world which has nearly the same amount of size and liquidity. But the effect on non-Treasury triple-A debt, including municipal bonds, might well be larger. And the long-term effect is likely to be huge: when looking for a safe haven, investors will henceforth have to stop and think about which one of various options are the least risky. The knee-jerk flight-to-quality trade will be a thing of the past, because nobody will really know what “quality” is any more. Specifically, would triple-A debt be safer than Treasuries, if Treasuries aren’t triple-A?
Again, this is something it’s impossible to answer ex ante. My gut feeling is that triple-A issuers like Johnson & Johnson or the World Bank would still trade at higher yields than the US Treasury, even if the US was downgraded and they weren’t. But in the first instance, there would be bound to be a lot of volatility, with weird price action and very unexpected correlations.
There is one interesting alternative, however. What would happen if, instead of downgrading the US specifically, the ratings agencies simply decided to abolish the triple-A rating entirely? The rating is dangerous and impossible: a triple-A default is a much more significant event than a double-A default. Taking the entire fixed-income universe and capping it at double-A would send a message to the markets that, sorry, there’s no such thing as risk-free debt: you can worry about rates all you like, but everything you own has some element of credit risk built in.
Taking the triple-A out of the ratings universe would, at one level, be purely cosmetic. It would be like removing the pinstripes from the Yankees’ uniform, or changing the markings on Nigel Tufnel’s guitar amp so that they only go to 10 rather than 11.
But appearance matters, especially in something as fragile and important as the global confidence game that is the fixed-income market. And abolishing the triple-A rating would be an admission on the part of the ratings agencies that in creating it, they built a monster. It is a monster which has been very good to the US, over the years; its death throes would be extremely painful. But a world without triple-A debt is a world where investors are more alive to the risks that they’re running. And ultimately that’s probably a good thing.