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When “Risk-Free” Isn’t Risk Free: The Impact of a US Treasury Downgrade

June 27, 2011

Many investors are on edge about the market’s reaction to a possible downgrade in US Treasury bond ratings if the near-term debt ceiling isn’t raised. Our view is that a deal will eventually be struck to keep the US from defaulting on its obligations.

But while the US political system may resolve the near-term fiscal crisis, it seems unable to address the long-term structural issues behind it. Rating agencies have put the US on notice that those issues could lead to a Treasury downgrade, regardless of whether the debt ceiling is raised. What would happen if US Treasury ratings were downgraded?

We researched the potential market impact by studying previous downgrades of sovereign debt. Our analysis suggests that the impact is likely to be modest. History indicates that when investors have remained confident that governments were committed to meeting their obligations, downgrades have had little effect. It’s a different story for downgrades that has taken place in the context of a broader economic or financial crisis, however; in those cases, the negative impact on yields has been much larger.

The longer-term question is whether the market will decide that the US is simply incapable of addressing the underlying structural issues with its entitlement programs. If that were to happen, our analysis would change significantly: The US might fall into the category of countries where sovereign downgrades accelerate an already-worsening fiscal situation. Based on Treasury yield movements, we’re not there yet.

Downgrades Have Historically Had Little Impact on High-Quality Sovereign Spreads
Impact of Ratings Downgrades on Spreads
Sequencing Data Chart
Historical analysis is not a guarantee of future results.
Based on data from January 1, 1990, through April 30, 2011
Source: Bloomberg, International Monetary Fund, Moody’s, S&P and AllianceBernstein

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