U.S. AAA credit rating in jeopardy as risks get reality check

Nearly three years after the financial system crash, the concept of investment risk continues to be turned on its head.

Things have happened in the markets and the economy that have far exceeded most people's worst-case scenarios. What many Americans thought they knew about investing turned out to be dead wrong.

That learning experience is speeding up again. Investors are being forced to rethink a generally accepted financial principle of the postwar era: that the world's developed nations are inherently low-risk places to put money.

The debt problems that have mushroomed in the U.S., Europe and Japan since 2008 have "shattered the concept of the major economies being stable, dependable investments," said Sean Egan, head of Egan-Jones Ratings Co., a smaller rival to Wall Street's credit-rating giants.

This week, two bigger credit raters, Moody's Investors Service and Standard & Poor's, warned that they might soon cut the U.S. government's top-rung AAA debt rating because of the political battle in Washington over the federal debt ceiling and spending cuts.

Think of it. U.S. Treasury bonds are supposed to be the world's "risk-free" asset, in the sense that there should be zero doubt about the government's willingness and ability to pay promised interest and repay principal in full. Treasuries have long been the benchmark by which the risk of other investments is measured. Other interest rates, such as mortgage rates, are set based on Treasury yields.

So it's monumental that S&P, in an announcement Thursday, said that if Congress and the Obama administration failed to agree on a "credible" plan to rein in deficit spending, it might drop its U.S. debt rating from AAA "into the AA category."

That would put the U.S. in with a group of countries that includes Japan, China, Spain and Slovenia. And America would be considered less creditworthy than remaining AAA-rated countries including Canada, Germany, Switzerland,Finland, Norway and Australia.

Finland: The new risk-free asset?

Still, in the realm of debt-rating-speak, a AA rating is considered "high quality." By contrast, that description no longer applies to bonds of Ireland andPortugal, according to Moody's. The firm this month cut both of those countries' ratings to the Ba level, which is the top rung of junk status, or non-investment-grade — i.e., speculative.

A junk rating for Ireland would have been inconceivable to the Irish people just a few years ago. The country's once fast-growing economy, the Celtic tiger of Europe, held Moody's top Aaa rating, or close to it, for most of the last two decades. But since 2009 Ireland's rating has been on a fast slide. Ditto for Portugal and, of course, for Greece, the epicenter of Europe's financial crisis.

The ratings firms — and, belatedly, investors — have come to realize how heavy the debt burdens of these countries have become and how difficult it will be for them to grow their way out of that debt. The same borrowing that fueled their growth since 1990 now is a millstone.

Ireland's public debt equals about 94% of its annual gross domestic product. Portugal's percentage is 83%. Greece's is a stunning 144%. By comparison, U.S. public debt is about 60% of GDP, not counting what's owed to government agencies such as Social Security.

At the other end of the debt spectrum from Western Europe are countries such as South Korea, Slovakia and Brazil, which have public-debt-to-GDP ratios of 24%, 41% and 61%, respectively. Not surprisingly, their investment-grade credit ratings have been untainted by the 2008 global financial crash and its aftereffects.

Greece, Portugal and Ireland, each of which has gone to the European Union for financial aid, now are caught in a vicious cycle: Investors are demanding double-digit market yields on their bonds to compensate for the risk implied by low credit ratings. The annualized yield on two-year Greek bonds is a stunning 33.1%; on Irish two-year bonds it's 23.1%.

If those rates are sustained, the countries will be unable to borrow what they need from investors to roll over maturing debt. Moody's says that makes it more likely the countries will need further help from the European Union — and that the EU eventually will require private bondholders to bear some of the bailout pain by writing off part of the debt.

The U.S., nearly everyone presumes, is a long way from the fates of Greece, Portugal and Ireland. Even so, with both Moody's and S&P threatening credit downgrades this week, it would be logical for some investors to feel a bit unnerved about Treasury bonds and demand higher interest rates.

Yet so far, that isn't happening. The yield on two-year Treasury notes ended Friday at a mere 0.36%, down from 0.39% a week ago and near the 2011 low of 0.33% reached June 24. The 10-year T-note yield ended the week at 2.91%, down from 3.03% a week ago.

Byron Wien, a veteran money manager at Blackstone Group in New York, has been predicting for the last year that the 10-year T-note yield would rise to 5%. "I've been very wrong," he said. "I am astonished" that yields remain so low.

Wall Street, usually prone to overreaction, remains underwhelmed by the ratings-cut threats. Why? There is disbelief that the cuts really will happen. Congress must raise the $14.3-trillion federal debt ceiling by Aug. 2 or risk the Treasury running out of money, but by Thursday there was talk in Washington of a compromise between President Obama and Republican leaders that would avert that potential debacle.

What's more, investors rightly are suspicious of the ratings firms. There is the sense that Moody's and S&P are playing hardball with Uncle Sam because their reputations are so tarnished by the many AAA ratings they handed out to mortgage bonds that crumbled with the housing bust.

Wien adds another reason investors keep funneling cash to Treasuries: "U.S. rates are so low because there's so much fear around the world." U.S. consumer confidence in the economy is plummeting again, to lows last seen in 2009. Europe's debt crisis has spread to Spain and Italy. The Middle East remains racked by social upheaval.

Meanwhile, the developing world has a different set of problems. China, India, Brazil and other fast-growing developing countries are tightening credit to curb inflation. That has whacked their stock markets this year while the Dow Jones industrial average holds on to a 7.8% year-to-date gain.

But looking out a few years, global investors are presented with two starkly different choices: Developed countries' onerous debt burdens will continue to retard growth, and those burdens will grow heavier if interest rates rise. For the developing world, where debt levels are light, growth prospects remain bright and interest rates could come down if inflation recedes.

Boiled down to that, it doesn't look like much of a competition.