A Q&A on S&P’s downgrade of US debt

Standard & Poor’s has taken the unprecedented step of lowering the top credit rating that the U.S. has held for nearly a century. A look at this downgrade, and downgrades in general ? and what they mean:

Q: What did Standard & Poor’s do?

A: The ratings agency downgraded the federal government’s long-term credit rating one level from the top AAA grade to AA+. S&P said political gridlock is preventing the country from dealing effectively with its debt burden.

Q: What does a downgrade mean?

A: A downgrade is a warning to buyers of bonds and other debt that the chance that they won’t get their money back has increased, however slightly. In theory, downgrades should lead to higher borrowing costs for the issuer (in this case, the government), since investors demand a higher interest rate if they’re taking a bigger risk.

Q: Does it mean U.S. interest rates will go up?

A: The 10-year Treasury note is considered the basis for all other interest rates, so higher rates on that and other long-term U.S. debt could lead to borrowing costs on everything from mortgage loans to credit cards. That would also make it more expensive for state and local governments, companies and consumers to borrow money.

But it’s not clear that investors will sell their Treasury notes in response to S&P’s downgrade, so it may have no effect on rates. Treasury bonds are a foundation of the U.S. financial system, and there are few safer alternatives that are easy to trade. As stocks plunged the last two weeks, price of Treasurys soared because demand was high, even though investors knew there might be a downgrade. Since yields on debt securities fall as prices rise, the yield on the 10-year note dropped from 2.96 percent on July 22 to 2.39 percent on Friday.

A downgrade could spur a “quick jolt of nervous, knee-jerk selling” of bonds, raising rates in the short term, said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott. But investors are so worried about the economy and need the safety of Treasurys that they could quickly become buyers again.

However, some money-market funds could be forced to sell U.S. government debt if they require client money to be invested in only AAA-rated debt.

Q: What did the other ratings agencies do?

A: The two other major agencies haven’t taken action yet. Moody’s Investor Service has said it might downgrade the U.S. rating, but its chief economist noted yesterday that Treasury securities “are still the gold standard.”

Q: How many times has the U.S. been downgraded below AAA?

A: Never. The U.S. has been rated AAA since 1917 and has only faced the threat of a downgrade once. In 1995, when Bill Clinton was president, a similar default loomed and the credit rating agencies warned of a downgrade. At the time, the country had $4.9 trillion in debt ? nearly $10 trillion less than now. Once Congress resolved that debt crisis a year later, the credit agencies removed their warning.

Q: How has a downgrade affected other countries?

A: In May 1998, S&P knocked Belgium, Italy and Spain from AAA to AA. A week later, their 10-year rates had barely budged. In some cases, rates actually fell. A week after S&P took Ireland’s AAA rating away in March 2009, 10-year rates in that country fell 0.18 percentage points.

Q: How big is the market for U.S. government bonds?

A: At $9.3 trillion, the U.S. government bond market is massive compared to other countries. Daily trading of Treasurys runs at $580 billion, far higher than British gilts ($34 billion) or German bunds ($28 billion), according to a recent study by Fitch.

“I think no matter what happens, Treasurys are the safe haven,” said Dan Greenhaus, chief global strategist at the brokerage BTIG in New York. “No other market is as large or as liquid.”

Treasurys have a solid appeal for the world’s central banks. China’s central bank holds an estimated $1.16 trillion. Japan, the second largest foreign owner, holds $912 billion.

Fitch said the status of the U.S. dollar and the size of the Treasury market are the biggest reasons investors won’t abandon Treasurys soon. The dollar is the global reserve currency, which means a significant amount of global trade is made in dollars ? from toys and computer chips from China, coffee from Kenya or cars from Japan. Central banks in other countries therefore hold large reserves of U.S. currency, mostly through Treasury purchases.

Q: How long will it take for the U.S. to regain an AAA rating?

A: Analysts say it could be tough for the U.S. to regain the AAA rating soon especially given its current economic challenges. S&P officials implied that it will take years to see a meaningful change in the U.S. fiscal situation and in the government’s decisiveness.

“If the economy won’t grow at 2.5 percent over the long term, it has pretty profound implications from a fiscal point of view,” said David Riley, managing director of Fitch Ratings. He said “that means the U.S. is poorer than it thought” and that legislators will face even tougher choices about taxes and spending.

Fitch also said that total U.S. government debt ? including state and local government debt ? will be as large as the country’s annual gross domestic product by the end of 2012. Further increases in the long term are not consistent with an AAA rating, the agency said. Similarly, Moody’s said for the U.S. to keep its AAA rating, it wants to see the federal government’s debt-to-GDP ratio stay near its projected 2012 level of 73 percent in the next several years, and then fall.