CONTRIBUTORS
Douglas A. Hulsey, CFA
On August 1, 2023, Fitch downgraded the long-term issuer rating of the United States by one notch, from AAA to AA+, citing “expected fiscal deterioration over the next three years,” as well as a growing general debt burden. Fitch had placed the US on Negative Watch in May 2023, citing the debt ceiling fight in Washington that was subsequently resolved on June 3, 2023. At the time, Fitch stated that “the repeated debt-limit political standoff and last-minute resolutions have eroded confidence in fiscal management.” With this downgrade, Fitch’s rating is now the same as S&P’s at AA+ (S&P downgraded the US in April 2011). It’s important to note that Moody’s retains its AAA rating with a Stable Outlook for the US. Additionally, Fitch affirmed the Country Ceiling for the US at AAA (which, if downgraded, would have had implications for other security types). The downgrade impacted a range of US government and government-related securities including US Treasuries (USTs) (41% of the Bloomberg Aggregate Index), derivatives associated with USTs (e.g., Treasury futures and options), TIPS, agency debentures (approximately 1.3% of the Bloomberg Aggregate Index), agency mortgages (27% of the Bloomberg Aggregate Index), agency to be announced (TBAs), agency commercial mortgage-backed securities (CMBS) (0.8% of the Bloomberg Aggregate Index), agency collateralized mortgage obligations (CMOs) and other related agency securities. The market reaction following the downgrade has been somewhat muted.
In terms of market impact, the Treasury yield curve has experienced a mild bear-steepening today, while the yields of maturities inside one year are basically unchanged. Western Asset’s view is that today’s reaction is likely a response to the US Treasury refunding announcement that confirmed increases in coupon Treasury supply rather than an explicit response to the Fitch downgrade. In particular, the Treasury announced on Monday that new debt issuance would rise to $1.007 trillion in 3Q23, up from $733 billion, with another $852 billion to come in 4Q23.1 This amount was in excess of what most market participants were expecting just a few days prior. The Money Market sector is functioning properly and the US dollar is mixed across major currencies, but generally a bit stronger. Agency MBS markets have exhibited a muted reaction to the Fitch downgrade. Mortgage TBA prices are marginally underperforming similar-duration USTs, a move consistent with the broader risk-off tone across markets today. Trading volumes are limited, but market liquidity is normal with bid/ask consistent with recent history.
The MBS issued by Fannie Mae and Freddie Mac (agencies) are secured by a beneficial interest in mortgage loans collateralized by residential properties or multifamily properties. The agencies guarantee timely payment of principal and interest cash flows to investors, but are not a part of the US government. As a result, they are not a debt obligation of the US; however, both Fannie Mae and Freddie Mac are federally regulated and have an implicit US government backing as well as lines of credit with the US Treasury. The agencies utilize prudent underwriting guidelines to evaluate the credit quality of the loans they guarantee to minimize losses. S&P, Moody’s and Fitch do not directly rate any MBS issued by the agencies; however, securities collateralized by agencies now carry the respective rating of the US government at AA+, Aaa and AA+, respectively. Fannie Mae and Freddie Mac currently have $69 billion and $39 billion of capital as of 2Q23, respectively; in addition, they have untapped lines of credit from the Treasury totaling $114 billion and $140 billion, respectively.2,3 The only scenario that they would need to draw on the Treasury credit lines would be one in which mortgage borrowers default broadly. Recovery values on the mortgage assets are poor, and the capital currently held by the government-sponsored enterprises (GSEs) is insufficient to make up the difference. However, we believe that scenario is unlikely to play out given current levels of employment, mortgage loans with low delinquency rates and significantly built-up home equity. Hence, the chances of the GSE guarantees actually coming into question as a result of the downgrade are remote.
The MBS issued by Ginnie Mae (GNMA) also guarantee investors the timely payment of principal and interest on MBS backed by federally insured or guaranteed loans. The loans are insured by the Federal Housing Administration (FHA), guaranteed by the Department of Veterans Affairs (VA), the Department of Agriculture’s Rural Development (RD) and the Department of Housing and Urban Development’s Office of Public and Indian Housing (PIH). GNMA securities are backed by the full faith and credit of the US government, and are explicitly guaranteed. GNMA MBS also now carry the respective S&P, Moody’s and Fitch rating of the US government at AA+, Aaa and AA+, respectively. GNMA has its own reserve fund with $28 billion of cash on hand as of September 30, 2022, that sits behind the advancing obligations of the servicers and the guarantees of FHA, VA, RD and PIH.4
Western Asset has maintained that both (1) rising debt levels and (2) demographic projections across developed markets (DMs) represent secular headwinds to global growth. Increasing debt levels across various DMs could be reasonably expected to be accompanied by downgrades from the rating agencies (at some point). While the Fitch downgrade does not come as a significant surprise, the timing is interesting as our view has been that a downgrade, if any, would have occurred during the debt ceiling negotiations back in May. It’s important to remember that the US government can comfortably meet its obligations and Western Asset doesn’t anticipate further downgrades in the near term.
Looking ahead, the next big milestone will be January 1, 2025, when the debt limit suspension ends. The US government has the ability to employ extraordinary measures to allow the government to continue meeting its obligations, but political jockeying heading into general elections may introduce uncertainty. Western Asset doesn’t envision the Fitch decision altering the Fed’s actions; interest rates should continue to be guided by incoming economic data such as nonfarm payrolls (NFP) on Friday and the Consumer Price Index (CPI) next week.
Endnotes
- Source: “Treasury Announces Marketable Borrowing Estimates,” US Department of the Treasury, July 31, 2023.
- Source: “Financial Supplement Q2 2023,” Fannie Mae, August 1, 2023.
- Source: “Freddie Mac Reports Second Quarter 2023 Financial Results,” Freddie Mac, August 2, 2023.
- Source: 2022 Annual Report, Ginnie Mae, November 14, 2022.
Definitions
"AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality, and are commonly referred to as "junk bonds."
The Bloomberg US Aggregate Bond Index is an unmanaged index that measures the performance of the investment grade universe of bonds issued in the United States. The index includes institutionally traded US Treasury, government sponsored, mortgage and corporate securities.
US Treasury inflation protected securities (TIPS) are a special type of Treasury note or bond that offers protection from inflation. Like other Treasuries, an inflation-indexed security pays interest six months and pays the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the Consumer Price Index (CPI.)
A debenture is a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer.
To be announced (TBA) serves as a contract to purchase or sell an MBS on a specific date, but it does not include information regarding the pool number, number of pools, or the exact amount that will be included in the transaction.
A Commercial Mortgage-Backed Securities (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property.
Collateralized mortgage obligations (CMO) are securities backed by a pool of pass-through securities, which consists of several classes of bondholders with varying maturities. The principal payments from the underlying pool of pass-through securities are used to retire the bonds on a priority basis as specified in the prospectus.
The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.
Government-sponsored enterprise (GSE) includes the Federal Home Loan Mortgage Corp (FHLMC), also known as Freddie Mac; and the Federal National Mortgage Association (FNMA), also known as Fannie Mae. GSEs were chartered by Congress in 1970 to keep money flowing to mortgage lenders in support of homeownership and rental housing for middle income Americans.
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Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.