Fitch Downgrades Long-Term U.S. Debt

Key Insights

• Fitch Ratings (Fitch) downgraded U.S. debt (treasury bonds) from AAA to AA+ on August 1, 2023.

• Drivers of the downgrade included fiscal challenges, rising debt levels, and the erosion of governance relative to peers.

• Standard and Poor’s (S&P) downgraded U.S. debt in 2011 which created short-term volatility in capital markets which quickly subsided

Fitch Downgrade

Fitch is an agency that evaluates the credit worthiness of governments and corporations. On Tuesday, Fitch, downgraded U.S. debt from AAA to AA+. Fitch’s AA+ rating still indicates a very high level of “investment grade” quality for U.S. debt moving forward. This announcement caught many investors by surprise as it was not widely anticipated by the markets and many of the reasons mentioned are well known. Fitch cited reasons for the downgrade to include fiscal challenges, a high and growing debt burden, and the repeated debt limit standoffs and last-minute resolutions by U.S. congress.

The timing of the downgrade was curious given it’s been over two months since congress reached a “debt ceiling” agreement in late-May. Nevertheless, the downgrade could create additional concerns for investors in an already uncertain economic environment. The S&P 500 Index declined on Wednesday (-1.4%) and treasury yields ticked modestly higher. However, the initial reaction was relatively muted, which may be an indication there is rising confidence in the U.S. economy. Although the economic landscape remains uncertain, a strong labor market, decades-low unemployment and resilient corporate earnings seem to be keeping volatility at bay for now.

Recent U.S. Debt Downgrades

S&P took a similar action to downgrade U.S. Debt in 2011, also reducing the rating from AAA to AA+. Also like the Fitch downgrade, the S&P downgrade followed a U.S. debt ceiling standoff, although the S&P announcement came almost immediately following the 2011 debt ceiling increase.  

Following the S&P downgrade in 2011, equity markets experienced a steep decline on the first trading day after the announcement, with the S&P 500 dropping almost 7%. However, the initial volatility quickly subsided, and the index recovered all its losses within two weeks of the downgrade. Bonds held up well throughout this period and provided ballast to diversified portfolios in the early stages of the downgrade.

Conclusion

It’s not uncommon for unexpected events to rattle capital markets and increase volatility. However, the impact can quickly fade as investors have time to digest the news. It may provide some comfort that the reaction to the latest downgrade was relatively benign. Further, equity markets bounced back quickly following a similar development in 2011. It’s important to remember market timing is extremely difficult and inopportune changes in asset allocation could be costly in the long run.

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