Though most holders of US Treasuries won’t be under pressure (yet) to reallocate their bond holdings, for a number of them a second ratings downgrade will change that.
This morning the suggestion is out that Moody’s will likely downgrade US Treasuries if the Bush tax cuts don’t expire as scheduled at the end of next year. I can’t picture the House majority going along with that, so insurance companies and pension funds who have ratings-based guidelines for their portfolio will have to start thinking about repositioning for a second downgrade.
Most who don’t know the bond market will probably think that action would result in selling pressure on Treasuries.
Au contraire, mon ami.
Selling pressure will show up in lower-rated bonds (perhaps junk bonds or emerging markets bonds). There would actually be incrementally higher demand for Treasuries.
How can this be?
It all comes down to weighted averages.
When a portfolio sets out its framework for credit risk, that framework typically lets the manager choose a variety of credits, including some outright junk. That’s how a bond fund manager earns his keep — by diving deep into dicier credits and doing the hard work to understand why the credit risk is worth taking.
At one of my prior professional lives, our fund management goal was to take what we thought was BB+ risk (high junk), but get paid B+ rates. If we were right, that spread difference was how we provided value to our customers.
Sometimes we got the incremental yield by doing private placements, lending directly to the borrower. They paid more yield, but didn’t have to suffer the expense and reporting hassles associated with issuing public debt. Sometimes it was literally by buying single-B bonds that we felt were likely to perform like double-B bonds (and maybe get upgraded).
No matter how you get there, it was typical that our assignments from pension funds or similar investors specified an average rating. The weightings were heavily slanted against the lower end of the spectrum. A dollar of double-B (BB) rated bonds might be weighted the same as fifty dollars of AAA bonds.
So, when your average rating slips down because the top-rated bonds are no longer AAA, the solution will be to sell the lowest-rated bonds that have a decent bid. That would be publicly traded junk and emerging markets bonds. A portfolio that holds a hundreds of millions in Treasuries can probably get back in compliance with its ratings guidelines by selling five or ten million single-B bonds from Asia.
It will be interesting to watch the political dart-throwing if Moody’s does follow through with the downgrade, and cites failure to raise taxes.
Pass the popcorn, please.