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A Downgrade of US Debt Won’t Matter as Much as You Think

A lot of people assume that if the ratings agencies downgrade the credit rating of the United States, it will trigger a sell-off of Treasurys. Some even suppose that a sell-off would be automatically triggered by regulatory and fund charter requirements.

Fortunately, this isn’t true.

It’s very likely that a downgrade of the credit rating of the U.S. would trigger a sell-off, but it’s far from clear that investors would sell U.S. government debt. More likely the investors would sell risk assets—equities, high yield corporate bonds, mortgage securities—and actually buy U.S. government debt.

What's certain is regulations won’t require most holders of Treasury debt to sell after a downgrade.

The logic of why investors would buy Treasurys even if they are downgraded is relatively simple. The downgrade would introduce a new level of fear into the market, and investors typically respond to fear by putting their money in “safe” and “liquid” investments. There is no more safe or liquid investment than the debt securities of the U.S. government, regardless of the rating. Someday this pattern could break, but that day almost certainly won’t be when the widely discredited ratings agencies downgrade U.S. debt.

So let us turn to the other point: the phony danger of an “automatic” sell-off triggered by regulations.

Megan McArdle at The Atlantic spelled out the logic behind this view:

Institutions like insurance companies have strict regulations about the quality of the assets they can buy, and S&P ratings, among other things, are the proxy that we use to judge credit quality. If [Atlantic national correspondent] James [Fallows] or I scream that the U.S. debt picture is unsustainable, we will not move markets. If S&P downgrades U.S. debt, this will trigger a sell-off, even if the people selling disagree with their assessment. Nor is there any easy way around this; the nature of regulation is to require hard metrics and bright lines, even if those metrics aren't very good.

But Megan’s just wrong about this. That’s not the way our regulations work.

It’s true that our regulations require many sorts of institutional investors, including pension funds and insurance companies, to hold “high quality” assets as a large portion of their investment portfolio. The same is true of many less-regulated investment funds that are controlled by their charters and prospectuses rather than direct regulation of their investments.

But what Megan misses is the way "high quality" is almost always defined. While it's true that regulations often require assets have the top ratings from ratings agencies, this isn’t true when it comes to debt issued by the U.S. government. Those are automatically permitted in most cases, regardless of how or whether they are rated.

Take New York’s life insurance law. It just issues blanket permission for life insurers to own obligations issued by “the United States of America or any agency or instrumentality thereof.” There’s not a ratings requirement at all.

Ratings are a very serious matter when it comes to the holding's corporate debt or the debt of foreign sovereigns by regulated institutional investors in the U.S. But when it comes to the debt of the U.S. government, they just don’t matter that much.

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