• Standard and Poor's (S&P) lowered its long-term credit rating on the United States to AA+ from AAA late Friday evening. At the same time, it affirmed the A-1+ short-term rating and removed both ratings from credit watch, but held the long-term outlook as negative. This means that another downgrade is possible within the next two years if there is less deficit reduction than expected or economic or financial conditions change.
• S&P's rationale for the downgrade was its assessment that the recently negotiated budget agreement fell short of what is needed to stabilize the rising US debt. An additional factor for S&P was the contentious nature of the budget process itself, which has reduced its confidence in the ability of policy makers to address rising US deficits.
• It's important to remember that a credit rating is an opinion issued by a private organization, not a seal of approval. And S&P is only one of three major rating agencies. The other two--Moody's Investors Service and Fitch Ratings--have not lowered their ratings, although they assigned a negative outlook. Nonetheless, credit ratings do matter. Investors use credit ratings as a standardized way of assessing and comparing the risks of various issuers and securities, just as banks often use credit scores to assess the risk of an individual borrower. It is only one of many metrics that investors use when buying bonds, but it is an important one.
• While the downgrade by S&P may be potentially disappointing for the markets, we don't believe that it will necessarily cause borrowing costs to rise or that it will have much impact on the real economy in the short run. It is the opinion of one entity, albeit an influential one, but our view is that the impact is likely to be limited. It may cause some erosion in investor confidence in the near term. Of course, if the longer-term budget issues are addressed in a credible way, we would expect confidence to recover.
• For investors who are concerned about the potential impact of the downgrade, we suggest a few small adjustments to bond portfolios to reduce exposure to riskier sectors of the fixed income market. In stocks, although the downgrade may heighten volatility, we don't see that as a reason to alter portfolios within the context of a long-term strategy and financial plan.

Why did S&P act now?
S&P has warned about the possibility of a downgrade several times in the recent past, but the timing of the actual downgrade was earlier than we, along with most market watchers, anticipated. It appears that both the political process and the substance of the budget deal were not sufficient to increase S&P's confidence in a credible plan for long-term deficit reduction. In its press release from Friday, August 5, S&P wrote, "the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics." It also criticized the political process surrounding the raising of the debt ceiling, indicating that it is "pessimistic" about the ability of Congress and the Administration to bridge their differences on budget issues and that this will remain a "contentious and fitful process."

In contrast, after the budget deal was reached and the debt ceiling raised, Moody's and Fitch confirmed that they did not change their ratings on US debt. Both still assign their highest ratings to US Treasuries although Moody's assigned a negative outlook, which means a downgrade is still possible or even probable if conditions don't improve.

How do rating agencies assign ratings?
When issuing a rating for a sovereign country, rating agencies consider many factors, including fiscal position, monetary policy, economic growth and outside influences, such as the amount of debt held by foreign countries. They also look at qualitative factors such as the political climate and then compare an issuer to its peers. On the qualitative side, S&P noted that the negative effect of the contentious political process offset other advantages unique to the United States. These advantages include the dollar's status as the world's reserve currency, which allows the United States access to global funding markets. In terms of quantitative measures, S&P compared the United States to a small group of other AAA sovereigns: Canada, the UK, France and Germany. Although the current US net debt-to-GDP ratio--estimated at 74%--is lower than some countries in the group, S&P believes that the trend in the US debt burden is going to diverge and move higher while the others will decline longer term. For more background on rating agencies and how ratings work, see " How to Use Bond Ratings Today."

How long does a downgrade last?
There is no set time period for a rating. Other AAA-rated nations that were downgraded in the past, such as Canada and Australia, took years to regain their AAA status. John Chambers, head of S&P's sovereign debt committee, said in news reports after the rating release that it could take some time for the AAA rating to be restored even if conditions improve. S&P also maintains a negative outlook on the AA+ rating and says that further downgrades could occur within the next two years if there isn't a more sustainable path for economic growth and deficit reduction.

Will this disrupt funding for the credit markets?
Fortunately, we believe that there will not be a major impact in the credit markets. S&P left the short-term US credit rating unchanged, and regulators have also said that the downgrade of US long-term debt won't affect risk-based capital requirements for US banks. This means that banks will not have to raise additional capital solely due to the downgrade. The Federal Reserve and Federal Deposit Insurance Corporation (FDIC) issued a statement that the downgrade will not change the way US Treasury securities are treated in calculating the need for bank capital. Therefore, banks should still be willing to lend to one another using T-bills as collateral.

Will the FDIC Insurance Fund be affected?
We don't believe so. The FDIC insurance provided for bank checking and savings accounts is backed by fees paid by banks and held in an FDIC Insurance Fund, as well as a line of credit to the US Treasury. The fund exists to insure deposits in the event of bank failures, and we do not believe the downgrade would cause bank failures or impact protections provided by the FDIC Insurance Fund on checking and savings accounts. For background on the FDIC Insurance Fund, see " How Secure Is the FDIC Deposit Insurance Fund?"

Will interest rates rise?
Not necessarily. Investors determine interest rates, not rating agencies. Moreover, the market was warned about a potential downgrade by S&P as early as April and yet interest rates have fallen sharply since then. Credit ratings are just one factor in the markets. In the short run, we believe slowing economic growth and uncertainty about Europe will continue to be supportive factors for low US interest rates. In fact, it appears that demand for US Treasuries as safe haven for assets has been strong recently. However, looking out longer term, S&P has highlighted that the serious budget issues facing the United States and the battle over the debt ceiling may have diminished confidence in US policymakers.

What about agency and municipal bonds?
S&P has said that it would also downgrade the debt of several government-related entities to correspond with the AA+ sovereign rating. These entities include Fannie Mae and Freddie Mac, as well as the Federal Home Loan Banks and Federal Farm Credit Banks. Along with US Treasuries, these issuers' debt and mortgage-backed securities are a sizable part of the taxable US bond market.

Moody's has indicated that it may downgrade bonds issued by federal agencies and systemically important banks due to their reliance on the federal government. This could lead to higher interest costs for those borrowers. It would also mean that investment funds holding these securities might see the value of their holdings decline. In addition, Moody's may downgrade ratings on five of the 15 states they currently rated Aaa--Maryland, Virginia, Tennessee, South Carolina and New Mexico--because of their dependence on federal revenue. Moody's stance on US debt is less aggressive: Aaa with a negative outlook.

Is there an impact on bonds and preferred securities issued by banks?
S&P has already indicated that a few systemically important banks--those whose boost in credit quality resulted from the support they received from the federal government during the 2008-09 credit crises--could be reviewed individually for downgrade. This may lower the value of the bonds and preferred securities issued by these banks.

What will foreign investors in US Treasuries do?
Nearly half of all Treasury securities are held by foreign investors. The largest individual holders outside the US are foreign central banks in Japan and China. Given the large trade surpluses that these countries run with the United States, they have large reserves of US dollars to invest. They have been gradually diversifying their holdings into other assets over the past decade, but for now there are few alternatives to US Treasuries for liquidity, transparency and relative safety.

How will this affect the stock market?
S&P's decision to downgrade the US credit rating is not a major surprise, since the company had been warning about it for quite some time. However, the timing was sooner than most market participants had expected and coming on the heels of a significant market decline during the past week, it might exert a negative impact initially.

Additionally, it is an unprecedented event for the United States, and to the extent that it reduces confidence in policy makers, it could be a negative. Longer term, we don't believe that by itself, the downgrade will have a long-lasting effect on the market. A credit rating, per se, shouldn't have an impact on the real economy or corporate earnings. Currently, Federal Reserve policy is accommodative and we expect the pace of economic growth to improve in the second half of the year. These factors should be supportive for the stock market.

Actions for concerned investors to consider