Does It Matter If the US Regains Its AAA Bond Rating?

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For years the U.S. government was looked to as the gold standard for good credit. Due to its taxing power and healthy finances, it was considered one of the safest investments in the world. After the recession, that picture changed.

In 2011, Standard & Poor's downgraded the United States' credit rating from AAA to AA+, giving the U.S. a lower rating at that time than Canada, Germany, and the United Kingdom. In fact, two U.S.-based companies had higher credit ratings than the country itself: Microsoft and Johnson & Johnson.

The map below illustrates nations color-coded by Standard & Poor's credit rating.

To gain a better sense of why this is, it helps to understand the factors that underpin the credit rating of a bond issuer. Ratings are assigned by major credit rating agencies such as Standard & Poor's (S&P), Moody's, and Fitch, and are based on the likelihood that the bond issuer will default. An institution's financial health, such as the strength of its balance sheet and cash position, is assessed to determine this likelihood. In addition to an institution's ability to service its debt via the cash left over after expenses are subtracted from revenue, the following are examined:

  • Earnings growth
  • Profit margins
  • Future outlook
  • Regulatory environment
  • Tax burden
  • Industry trends

The agencies rate each issuer on a letter scale based on these and other criteria. The ratings differ somewhat between the three agencies, but the highest-ranking—AAA for Fitch and S&P, and Aaa for Moody's—indicates that the borrowing entity is extremely unlikely to default on its debts.

Government Downgrade

Due to its rising debt, continued budget deficits, and sharply deteriorating debt-to-GDP ratio, the U.S. is no longer seen as offering the same degree of long-term safety it did even as recently as the late 1990s. From the perspective of its credit rating, the most important event occurred in August 2011, when S&P downgraded United States' debt from AAA to its second-highest rating, AA+. The primary reason S&P cited for its downgrade was the lower degree of predictability in the U.S. political picture, which raised the uncertainty of wrangling associated with issues such as the debt ceiling.

Alone, the downgrade didn't have a meaningful impact on the market. The other two agencies retained their high ratings, and even S&P itself distinguishes the difference between AAA and AA as being an "extremely strong capacity to meet financial commitments" versus a "very strong capacity" to do so.

The fact that the U.S. was no longer afforded the highest ranking by all three agencies, whereas Microsoft and Johnson & Johnson both retain that status, means that the two companies are seen as having lower credit risk than the government. This advantage is justified in the sense that both companies have much better debt profiles than the country as a whole. However, the U.S. can monetize or pay off its debt by printing money and using taxation powers—something that can't be said for corporations.

The AAA Rating Isn’t Everything

When comparing the bonds of these corporations to U.S. Treasuries, it is important to keep a few issues in mind. To begin, even though these two companies are more highly rated than the U.S. government, they also continue to offer higher yields since corporate bonds trade at a higher yield than government bonds. This gap is known as the yield spread. Since these companies are so financially strong, and therefore at lower risk of default, their spreads are typically lower than the average corporate bond.

Ratings, while useful, are by no means the only consideration an investor should have when choosing a bond.

No matter how highly rated the issuer, the performance of its bonds—particularly longer-term issues—is affected by interest rate and credit risks. Just because a bond is rated AAA doesn't mean the investor is completely safe from the effects of fluctuations in their principal. While AAA is the highest rating, bonds rated AA, or the equivalent, are extremely safe in terms of the rarity of default.