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Partner Insight: Limited impact expected from US credit downgrade

For only the second time in its history, the US saw its credit rating downgraded. Vanguard experts encourage investors not to overreact, however.

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Partner Insight: Limited impact expected from US credit downgrade

Key points

  • For only the second time in its history, the US saw its credit rating downgraded.
  • As the markets digest the news of the downgrade, we can expect some volatility. However, the near-term ramifications for the US of a credit-rating downgrade are relatively minor.
  • Investors should not try to time the markets’ reactions to shocks such as this downgrade on US debt but to keep their eyes on their long-term investment goals. 

The US avoided an unprecedented debt default in early June but not—it turns out—a credit-rating downgrade. That arrived on 1 August, when for only the second time in its history, the US saw its credit rating downgraded. While Fitch Ratings lowered the US government's long-term credit rating from AAA to AA+ earlier this week, Vanguard's investment and thought leaders have encouraged investors not to overreact.

As the markets digest the news of the downgrade, we can expect some volatility. The question is if a US credit rating that is now lower than that of countries like Luxembourg and Singapore—and about on par with Finland and New Zealand—is appropriate, given the global safe-haven status of US debt.

However, the near-term ramifications for the US of a credit-rating downgrade are relatively minor. Investors still perceive the US as having a strong willingness and ability to fulfill its obligations. In lowering the US credit rating, Fitch cited a trio of factors: ". . . expected fiscal deterioration over the next three years, a high and growing general government debt burden and the erosion of governance relative to ‘AA' and ‘AAA' rated peers over the last two decades."

Previous US credit downgrade did not have long-lasting consequences

The last time a credit-rating agency downgraded US debt was in 2011, when Standard & Poor's downgraded the government's rating from AAA to AA+. Then, as in the spring of 2023, the US Congress and the White House reached an agreement to raise the debt ceiling only days before the Treasury would have exhausted its cash reserves.

There was heightened volatility in both the equity and fixed income markets back then, but that was more due to the debt ceiling impasse rather than from the credit downgrade itself. The market impact of Fitch's rating action may not be clear immediately, but it's worth noting that the credit downgrade in 2011 didn't have long-lasting consequences.

Moreover, after the 2011 downgrade, investors flocked to US Treasuries, pushing yields down slightly, not up. Global investors, institutions and foreign governments all rely on Treasuries. Right now, there are few alternatives to Treasuries as a way to invest in the world's reserve currency, which is the US dollar.

That said, yields could stay higher for a longer period.

US fiscal challenges could be reflected in higher yields

The downgrade does highlight some medium-term challenges for the US fiscal outlook, however.
If these challenges are left unaddressed, it is possible that investors could start to demand a higher risk premium of the US Treasury's borrowing costs.

Whatever the full ramifications on the markets and the economy,  we at Vanguard continue to encourage investors to stay the course and not try to time the markets' reactions to shocks, such as the downgrade on US debt.

Investors should keep their eyes on their medium- or long-term investment goals, while trusting that portfolio diversification can smooth some of the choppiness in the markets. For investors that prefer a more active approach around macroeconomic events, a valid alternative could be to add a trusted active manager to their portfolio and rely on their professional judgment to navigate risks or even find prudent opportunities amid the confusion.

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Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

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Issued in Switzerland by Vanguard Investments Switzerland GmbH.

Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.

© 2023 Vanguard Group (Ireland) Limited. All rights reserved.

© 2023 Vanguard Investments Switzerland GmbH. All rights reserved.

© 2023 Vanguard Asset Management, Limited. All rights reserved.

This post is funded by Vanguard

Key points

  • For only the second time in its history, the US saw its credit rating downgraded.
  • As the markets digest the news of the downgrade, we can expect some volatility. However, the near-term ramifications for the US of a credit-rating downgrade are relatively minor.
  • Investors should not try to time the markets’ reactions to shocks such as this downgrade on US debt but to keep their eyes on their long-term investment goals. 

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