VettaFi Voices on: Implications of the Fitch Downgrade

Good morning, VettaFi Voices! On Tuesday, Fitch downgraded its rating on the U.S., largely due to political risk and fiscal concerns. A lot of industry figures have dismissed the move as puzzling or ill-advised, but is it a harbinger of negative market and economic data to come? What’s the big picture with regard to this move? And what should investors be concerned about in relation to the news?

Todd Rosenbluth, director of research: Fitch is the second major rating agency to downgrade the U.S. from AAA, but this time feels different. I remember 2011 when S&P did the same in the middle of what seemed like unprecedented moves in Congress to avoid raising the debt ceiling. The stock market fell sharply and there was a lot of panic. I happened to work for a different part of S&P at the time (as a fund analyst) and went to a client event that night that resulted in me repeatedly explaining what I did and did not do in my job.

In 2023, there has been tremendous demand for Treasuries, particularly on the ETF front. BondBloxx, a relatively new entrant, just crossed $2 billion asset mark due to demand for its Treasury bond ETFs, the BondBloxx Bloomberg Six Month Target Duration US Treasury ETF (XHLF ) and the BondBloxx Bloomberg One Year Target Duration US Treasury ETF (XONE ). ts peer F/M investments also just passed $2 billion with $1.3 billion of that in the low risk Treasury bond ETF, the U.S. Treasury 3 Month Bill ETF (TBIL A). F/M will turn one year old in August, so that’s an impressive cash haul.

Meanwhile, the most popular fixed income ETFs this year, according to VettaFi’s LOGICLY data is the iShares 20+ Year Treasury Bond ETF (TLT B-), which gathered $15 billion. Others in the top-10 include the following:

• iShares 7-10 Year Treasury Bond ETF (IEF B)
• Vanguard Long-Term Treasury ETF (VGLT A-)
• Vanguard Short-Term Treasury ETF (VGSH A+)
• WisdomTree Floating Rate Treasury Fund (USFR A-)

Advisors and investors continue to turn to Treasury ETFs for their stability and liquidity.

During VettaFi’s recent Fixed Income Symposium last week before the ratings cut, we asked attendees “How do you plan on changing your allocation to government bonds in the next 12 months?” While the majority (54%) said maintain current allocation, more people planned to increase (35%) rather than decrease (11%).

While some people may be more willing to shift to investment grade corporate bonds since the credit risks are more aligned now, I think Treasuries will continue to have a place in many portfolios. They serve as a core and are a healthy stake in broad index ETFs like the iShares Core U.S. Aggregate Bond ETF (AGG A) and the Vanguard Total Bond Market ETF (BND A).

I would note that as I type this Thursday 10am the 10-year Treasury yield has climbed to 4.18%. It was below 4.0% prior to the rating cut. As a reminder, Treasury yields climb higher when people sell Treasuries.

Lara Crigger, editor in chief: My sense is that, despite the initial rumbles in the markets after the downgrade, this will really prove to be a tempest in a teapot. It will likely unnerve investors and lead to some short-term volatility in higher-risk corners of the market.

However, memories are short, and I don’t foresee investors pulling back en masse from Treasuries any time soon, not given the flows so far this year, which Todd highlighted. Besides, unless I’m missing something here, an AA+ rating isn’t catastrophic. It puts us in line with other stable, well-developed economies like France.

Roxanna Islam Swan, associate director of research: I don’t think it’s necessarily a harbinger of negative economic data. It doesn’t really reflect any “new news,” but since many investors are already uneasy, it can add to that feeling. I think there’s so many other things on top of investor’s minds that this isn’t really going to make a huge impact in the long run. Apple and Amazon are reporting earnings today [Thursday]. I think even that has the potential to drive more impact in the broader U.S. markets than the Fitch downgrade. 

Rosenbluth: I agree, Roxanna. The Invesco QQQ Shares (QQQ B+) and the SPDR S&P 500 ETF Trust (SPY A) will be driven more by earnings news this week than by investors fearful of the added credit risk for U.S. government bonds.

Crigger: The other thing too is, like Todd said, we’ve already been AA+ for 10+ years, according to S&P. What new information is the downgrade really telling us? Not much, in my opinion.

Rosenbluth: I just was reminded that Microsoft and Johnson are the only two U.S.  companies with AAA credit ratings. I agree, Lara, that AA+ is still quite good. But I think Americans would like to be viewed more favorably than others in Europe. I’m intentionally leaving my politics out of this, but Fitch’s downgrade is clearly a reflection of the inability of the two parties to agree on government spending.

Swan: Yes, and those issues have been ongoing for a while now, which is why the timing is odd. There’s been a lot of other positive signals in the economy recently that to me, overshadow some of the reasons that Fitch cited.

Crigger: Do we think this downgrade had been decided for a while, and it just took time for it to be published and disseminated to markets? I admit, I don’t know much about the workflow of ratings agencies.

Swan: I was actually thinking that too! But I wasn’t sure. Thinking back to my days at sell-side firms where a ratings downgrade on a stock could take up to a day to get approved, it makes sense it would be much, much longer when you’re downgrading something really important – like the U.S. government.

Rosenbluth: Fitch put the AAA rating on credit watch negative in May, before the debt limit was raised. So they had to either downgrade or remove the watch negative and say all is well, the US government is stable.

Crigger: So maybe the downgrade is coming at a fortuitous time, buried in earnings season buzz, where it will make the least impact on the markets.

Heather Bell, managing editor: But is a one-notch downgrade really going to cause anyone to change their allocation?

Rosenbluth: In my view, no, the downgrade should not cause an advisor to shift to investment grade corporate bond ETFs like the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD A) or Vanguard Intermediate-Term Corporate Bond ETF (VCIT A). Some already preferred that investment style.

During the same fixed income symposium, we also asked "Which style do you see making the largest contribution to in the next 12 months? Investment grade corporate bonds was most popular (44% of the responses) with 25% of the respondents choosing Treasuries. High yield and money markets were the two other options and they got fewer votes.

Do I think the 25% that liked Treasuries most are going to shift based on the downgrade? No. If you believed the US government was the best credit available, you likely still do. But are there institutions that might need to rethink exposure because they have mandates to invest in only AAA? Perhaps.

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