Standard & Poor's downgrading of U.S. government debt presents institutional investors, including defined benefit and defined contribution retirement plans, with new challenges.
The downgrade to AA+ from AAA means more uncertainty and more risk in the capital markets, and it weakens the safe harbor of the historically risk-free Treasury securities.
In the fixed-income market, however, the reaction was different than expected. On the first trading day following the downgrading, Treasury prices rose and rates fell, as investors fled stocks to perceived safer Treasury securities. In fact, the reaction was counterintuitive. The downgrading should have made investors more wary of Treasuries as it implied the federal government might eventually be unable to pay the promised interest on them.
But while the market might regard Treasury securities as weaker, in reality, it still treats them as very safe investments because of a lack of an alternative. Could any company come to the market immediately after a downgrading and receive such a positive boost to its bond prices?
Unlike the fixed-income market, stocks reacted negatively to the downgrade, and volatility was high in the days following.
The volatility in the stock market shows the value of institutional investors with long investment horizons having strong investment policies. Such policies provide the discipline to resist the temptation to make short-term moves in reaction to market changes.
It also shows the advantage of having a diversified portfolio, for while stocks fell, Treasuries rose in price, as did corporate bonds. Likewise, hedge funds that had shorted the market would have prospered.
The decline in interest rates following the debt downgrade, and the Federal Reserve's announced intention to keep the Fed funds interest rate at or near zero for the next two years, are bad news for sponsors of defined benefit plans.
Logically, they might have expected interest rates to rise following the downgrade, easing their unfunded liabilities. Instead, rates have fallen, worsening the funding situation. If rates do not begin to rise soon, unlikely given the Fed's stated policy, more plan sponsors will be tempted to terminate their plans. Low rates also likely will cause those sponsors continuing their plans to defer moves to liability-driven investing to stabilize pension funding.
At the same time, low interest rates could soon make stocks more attractive because of their relatively higher dividend yield, helping funding levels and boosting economic activity.
For defined contribution participants, the implications are less clear. Those abandoning equities and moving into bonds could suffer losses if rates rise, driving bond prices down. And moving large allocations into cash for the long term would hurt participants' portfolio growth.
Easing such concerns are surveys showing that DC participants, in aggregate, tend to make few changes to their portfolios in reaction to volatility. Such inertia is fortunate for those with long-term allocation tilted toward risk and growth, but harmful to those keeping their allocations in safe, low-returning assets.
The Treasury downgrade is a symptom of increased political risk, and the result is more frequent tumult in the investment markets.
The Obama administration and Congress failed to take serious steps to reduce federal deficits and debt in the long term, pushing the problem onto a bipartisan committee that will have difficulty coming to agreement. A similar unresolved debt situation in Europe worsened markets' uncertainty.
But the U.S. debt problem isn't intractable. The Simpson-Bowles Commission on debt reduction produced a plan that many Democrats and Republicans in Congress seemed likely to accept, but the Obama administration ignored it. A separate proposed cut, cap and balance policy could bring meaningful restraint on the federal deficit and debt to promote restoration of the U.S. top credit rating and economic recovery with stronger fiscal policy, but the Senate and the White House couldn't accept it.
The downgrade and the stock market reaction have sent a strong message: All sides must compromise on a serious long-term program to reduce the federal deficits and debt. Until that happens, institutional investors have to prepare for continued uncertainty in the financial markets.
