M&G's Leaviss: The impact of the US downgrade on bonds

Jim Leaviss, head of retail fixed interest at M&G, discusses the impact on bond markets of S&P's downgrade of the US' credit rating.

Friday's downgrade of the US by ratings agency Standard & Poor’s appeared to come as a surprise to many market participants and commentators - even though the writing had been on the wall for some time.

The downgrade affects more than $9trn – that’s 9,000 billion dollars – of American treasury bonds. S&P doubts the effectiveness, stability and predictability of the financial policy hammered out on Capitol Hill over the past week or so.

In other words, investors can no longer assume Washington will honour its debts, whatever the market conditions.

Standard & Poor’s has said the outlook for the US remains negative, with a one-in-three chance of a further downgrade if there are no spending cuts, or if there is further deterioration in its economic outlook.

To give the downgrade some perspective, the default rate for AA+ credit is around 0.1% over a 10-year period, so it does not mean the US is going to default imminently.

However, there is now a much smaller pool of AAA-rated assets investors can buy, as US government debt formed approximately 55% of the world's AAA market up until Friday.

The loss of a AAA-rating does not mean bond yields are necessarily affected - for instance, Japan lost its AAA-rating yet its bond yields are still at exceptionally low levels.

The US downgrade has not caused a big reaction in the yields of US treasuries - in fact, 10-year US yields were trading about 7bp lower earlier today.

S&P kept its short-term outlook for US credit as stable, so it is unlikely money market funds will be forced sellers of US treasuries. It does not change the levels of capital that banks need to keep.

The European Central Bank (ECB) last night announced its securities market programme would be used more aggressively, and today it has been buying Italian and Spanish debt in large amounts. This has caused a big rally in those assets, with 10-year yields 70bp to 80bp lower. Credit default swap spreads have also fallen significantly.

Four years since the ECB first intervened in the money markets, we believe the credit crisis has never really ended, and recent interventions are just another example of 'kicking the can down the road'.

What this means for bond fund managers is credit analysis of governments is now as important as for corporate bonds. The stresses of 2008 are re-emerging, and interbank lending rates have increased, as banks are again refusing to trust each other. The result is that they are not lending, once again leaving central banks as the lenders of last resort.

There is the potential that the crisis will cause economic growth to decline in the foreseeable future.

The M&G retail fixed interest team has minimal exposure to peripheral eurozone sovereign debt, due to the fund managers' concerns over a possible default.

We have been actively adding to AAA-government exposure such as US, UK, German and Norwegian government bonds. Additionally, our bond funds remain underweight financials relative to benchmarks, and, we believe, to many of our peers, due to the fund managers generally retaining their negative view of banks.

Our financials exposure tends to be in those companies that are systemically important and have avoided state assistance.