American elected officials and taxpayers ignore at their own peril the recent May 16 reduction in the US credit rating. From the highest AAA rating to the next-lower Aa1 rating by Moody’s Ratings, this reduction is the third since 2011, when S&P Global Ratings reduced its rating, followed by Fitch Ratings in 2023.
It does not, however, mean that the US government may default on its Treasury bond obligations or fail to make interest payments on that debt. Rather, the three ratings agencies lowered their ratings because of mounting federal debt (currently over $36 trillion, 122 percent of US GDP) and annual budget deficits (currently about $1.7 trillion, 6.2 percent of GDP). Most economists consider these levels unsustainable.
Yawns and Indifference
This latest rating downgrade met with little fanfare. Stock market investors seemed almost indifferent to the news; stock indices have moved up and down in the intervening days and weeks, with no discernible pattern. There has been no dramatic stock market plunge similar to that following President Trump’s April 2 “Liberation Day” announcement of his reciprocal tariff proposal.
The US Treasury bond market, however, did not shake off the lower credit rating quite so easily. Investors reacted by selling some of their existing bond holdings, as they had been doing for a few weeks. A $16 billion auction of new 20-year Treasury bonds on May 21 produced a yield above 5.00 percent, the highest since 2023. The following day the yield on the 30-year bond rose above its 2023 level to the highest since 2007. This portends higher interest rates on upcoming US Treasury bond auctions, since federal budget deficits are likely to increase the need for borrowed funds to pay the government’s bills.
Some Bond Ratings Basics
Credit rating agencies are private firms, designated by the US Securities and Exchange Commission, that charge fees to bond issuers—both private businesses and public entities—to assess the creditworthiness of both outstanding debt and upcoming debt issuance. AAA is the highest rating offered by all three agencies, though the three differ in their lower ratings. S&P’s AA+ rating, for example, is equivalent to Moody’s Aa1 and to Fitch’s AA+.
The further down the alphabet a bond rating is, the higher the possibility of the issuer defaulting or not meeting its financial obligations. Classification as “investment grade,” for example, requires a rating of BBB- or higher by Standard & Poor’s and Fitch, or Baa3 or higher by Moody’s.
Lower S&P ratings and their indications include:
- CCC – an issuer is currently vulnerable and is dependent upon favorable conditions to meet its financial commitments
- R – an issuer is under regulatory supervision owning to its financial condition
- SD – issuer has selectively defaulted on some obligations
- D – issuer has defaulted on obligations and it may generally default on most or all obligations
- NR – not rated, which can mean that the issuer has simply chosen not to pay the usual fee for a rating
Note that there is no specific letter that indicates “junk” rating, though one does hear this term applied to some securities. “Junk,” used colloquially, usually means a bond rating below BBB- (S&P or Fitch) or Baa3 (Moody’s).
Is There Always a Market for US Treasury Securities?
The short answer to this question is yes, because a group of private financial institutions called “primary dealers,” carefully vetted by the Federal Reserve, stand ready at all times to make a market for Treasury debt. These dealers—typically major banks and other private firms in Wall Street and other financial capitals—maintain their own inventories of Treasury securities, which they buy from (or sell to) investors, including the Fed itself, making a small profit between bid and ask prices on each trade.
The longer, more nuanced answer to the question is, however, yes, there is always a market but yields cannot be guaranteed. To cite a stark example, if an investor bought $100,000 of those recently-issued 20-year Treasury bonds mentioned above at a 5 percent coupon yield, planning to hold them until maturity in 2045, he will receive $5,000 (5 percent of $100,000) annual interest payments, an amount that remains constant for 20 years.
But if consumer prices double between 2025 and 2045 because of rising inflation, the real purchasing power of the bonds he had bought in 2025 would be halved. While these bonds have—in fixed-income lingo—virtually no credit risk (assuming the US government retains its investment-grade rating), they can have potential untold interest-rate and inflation risk.
Consider another stark example of interest rate risk if market interest rates rose from 5 percent in 2025 to 8 percent sometime before 2045, with all new bonds now paying 8 percent. If the investor chose to sell his 5 percent coupon bonds at this time, the principal price he could receive for them would have fallen from $100,000 to $62,500. This is because the fixed coupon interest of $5,000 represents 8 percent of $62,500, and a buyer would be willing to pay only $62,500 for bonds with a face value of $100,000 when all newly-issued bonds are selling at 8 percent coupon rates. As a general rule, when interest rates rise the market price of fixed-income securities always falls, and vice versa.
Warning to Trump: Be Careful What You Wish For
Trump’s bete noire—and the underlying rationale for his import tariffs—is the persistent US trade deficit, about which he has complained for many years. In his rhetoric about trade deficits, however, he typically focuses on the US deficit in goods (merchandise), ignoring the smaller US trade surplus in services, which includes insurance, computer services, transportation, intellectual property, financial services, and travel.
He also needs to realize that since US capital inflows are the mirror image of US trade deficits, he ignores the large capital surpluses that US trading partners send back as they purchase US Treasury bonds that the federal government must issue in order to cover its annual budget deficits, as well to redeem and retire maturing bonds.
Thus, while Americans import large amounts of cheap foreign-made merchandise that they enjoy consuming (think Trump’s example of two versus twenty children’s dolls from China), they at the same time export IOUs representing federal debt that the US Treasury issues in order to support federal programs that benefit Americans. This simple truth belies the reality that those IOUs must someday be repaid by future generations of Americans (including the little girls who play with those cheap dolls from China).
Thus Trump, in his zeal to impose tariffs to reduce trade deficits, must be careful what he wishes for. The reality is that without those large trade deficits, US trading partners would not have the large capital surpluses with which to purchase US Treasury debt. The very countries with which the US has consistent trade deficits—China, the EU, Mexico, Canada, Japan, and UK—are also countries that collectively own about 30 percent of US Treasury debt—Japan, China, UK, and various others.
Do US Sovereign Debt Ratings Really Matter?
Investors today are concerned that the US Treasury’s borrowing needs are projected to increase due to inexorably rising federal budget deficits and outstanding debt, Congress’s inability to control federal spending, and/or inflation. Higher inflation in itself may necessarily follow the increased need for borrowed funds, especially if the Federal Reserve executes loose monetary policy as it did during the 2020-23 pandemic in order to accommodate higher Treasury bond issuance during that emergency.
Since the US Treasury depends so heavily on foreign bond buyers, the bright spot is that trade deficits provide them with trade surpluses, which they use to buy US federal government debt. These foreign investors—both governments and private parties—appear little daunted in buying and holding US debt, though their appetite for US debt could conceivably fade over time.
It’s as if the US economy is perceived as so monolithically large and robust, its constitutional government is so stable (if not necessarily capable), and its taxpayers so dependably reliable paying their taxes, that nothing can match the US’s appeal to foreign investors. Perhaps they simply perceive that there may be no other reasonable options for investing their large US dollar-denominated foreign exchange balances.
If Congress were someday able to control its spending impulses, US borrowing needs might decline significantly. Recall that during President Bill Clinton’s administration the US actually experienced a federal budget surplus from 1998- 2001. Some in government, such as then-Chairmen of the Federal Reserve Alan Greenspan, expressed concern that, at some point, there would be insufficient Treasury debt for the Fed to execute open market operations. While this possibility seems oddly quaint from today’s perspective, the concern at the time was genuine.
There is little indication today that the US credit rating would ever decline to any level below investment grade. Nonetheless, American leaders and taxpayers delude themselves in thinking that debt ratings have no significance to the country’s ability to provide the current services on which today’s generations depend and the entitlement programs that future generations expect.
Editor’s Note: Jane L. Johnson, who had become popular with many of our readers, recently passed away. We will miss her intelligent copy and the many lively emails she sent to the editors. This was the last article she submitted to us. Rest in peace.
