What the S&P Downgrade Means for Investors

Eric Jacobson: Glad to be with you, Jason. Thanks.

Stipp: So the first question for you, S&P lowered the outlook to negative, but they didn’t change the rating. Can you explain a little bit about, what this means. So the rating is still the same, but now it’s the negative outlook instead of a neutral one. What should we take away from this change?

Jacobson: Well, I think that S&P probably looks at this as something like a warning. The language that they released with their message indicates that they are kind of worried about political decisions over the next couple of years and whether or not the Congress and the White House are going to be able to work together and so forth, and actually come up with some sort of maybe not even solution, but some sort of positive action to get our fiscal house in order, and they seem to be pretty concerned that it’s going to take a lot longer than we all hope, I guess, in the sense that it could last well past the election cycle and beyond.

Stipp: So Eric, what sorts of things are they looking at? What triggers this decision all of a sudden on a Monday?

Jacobson: Sure. Well, first off I'll say that, I had conversation with Laird Landmann. He is a senior portfolio manager at TCW/MetWest and his phrase was that sovereign credit ratings are black art and I think that’s right on the money. Because even though that there are lot of what we might call metrics that they can look at, and that they do look at, and really there are lot--S&P cites at least nine levels that are part of their analysis, and they include things like debt levels relative to GDP and whether your economy is diverse, what its sources of revenue and spending are, whether or not your central bank is independent, there are lots and lots of things. There are actually ratings both for bonds that are denominated in your own currency and foreign currency. But all that aside, like I said, being a little bit of a black art, a lot of it is very qualitative. They are talking right now about what’s going in Congress and so forth.

So, you can imagine, a big part of it is, are you as a country going to make a decision to pay or not pay? Are you going to make the decisions necessary to get your house in order?

And the thinking is, is that especially a country like United States certainly has the capacity to do that, there are lots of paths to it, and getting right if you will in terms of our fiscal situation, but they are trying to handicap to some degree what the risks are that politically we may just choose not to.

Stipp: We saw the stock market react [Monday], can you talk a little bit about what you saw in the bond market--so you would think that if there was a rating downgrade that certain bonds would sell off because supposedly the credit risk is now being recognized as being higher. Is that what we saw [Monday]?

Jacobson: Well, it’s a really complicated story, because if you look at default swaps as they exist on sovereign credits, United States default swaps at least last time I heard about the data earlier [Monday], as we say they widen a little bit. In other words, the cost of protection against the U.S. default actually went up by about 10 basis points.

On the other hand, despite the pain the stock market, the bond market actually eventually rallied. The shorter maturities were up earlier in the day and then eventually by the end of the day the 30-year bond wound up rallying as well.

There are a lot of different ways one can interpret it. Some of them have to do with the fact that this was potentially priced in already. The fact of the matter is S&P didn’t tell us anything new today; it really just sort of affirmed what a lot of people were thinking, and it was kind of a step of the rating agency actually coming out and saying it.

But there are a lot of other things that go on in terms of bond markets, and to some degree you know when there is fear and things like that, and people start discounting in what all the ramifications might and they "run for safety," believe it or not they might actually run towards Treasures. I know it sounds counterintuitive.

But the most important thing, I think, is that conversations have already been going on, and people have been expecting this kind of talk coming. I don’t think it was a big shock to anybody. It's just more the kind of thing where the concept is foreign because we are so used to having a AAA rating.

Stipp: So that rating still is staying at AAA, though the S&P outlook is more negative now. You mentioned that the cost of insurance against default went up a little bit based on the market trading [Monday]. Are we seriously at a bigger risk of default now? Would the U.S. default, or what are the likely scenarios of this playing out with the U.S. government.

Jacobson: Sure I don’t think anyone actually believes that the U.S. is at a major risk for default--certainly not now. And frankly even if we get to the point where we are talking about it down the line, I think most people who will follow these things carefully believe that the bigger risk is inflation being generated by the production of more currency, if you will. In other words, we have the capacity, people like to say we have our own printing press. We have the capacity to print more dollars, absorb more debt, things like that, and essentially cause inflation. And inflation actually lowers the cost of the United States of having to pay off its debt over time. And so there are a lot of different ways you can describe that: Some people might call it a "polite" or maybe "impolite" fault. They can call it a "soft default"--there are lots of ways you can describe, but the likelihood is that’s a much bigger possibility than the U.S. actually saying "hey--we are done; we are not paying off some of our debts."

The process of that happening, to the degree that it does even go in that direction, is pretty incremental, and as you said, I think S&P is more worried about what's going to happen the next couple of years.

And frankly, I think the biggest concern right now is that we’re at this sort of political crossroads, where everyone’s at loggerheads, and we're getting closer to an election, and there is some fear that we could just put our problems off for another couple of years. And by that point, who knows what situation we’re going to be in both economically, fiscally, and politically. So that’s kind of the worry that we’re at right now.

Stipp: We both know markets hate uncertainty.

So, the last thing I wanted to ask you, Eric, obviously there was some trade at least, some trading in the stock market based off of this.

As an investor, do you make a change based on news like this? Or should you think about your portfolio differently in any way? What steps would you take if you were going to, say, look at your portfolio and do an examination based on the news [Monday]?

Jacobson: Sure. I probably wouldn’t act specifically on the news that came out [Monday], but hopefully people had an idea that this is the kind of thing that’s talked about in financial markets.

It really depends on what your capacity is for volatility and your capacity is for risk--because the fact of the matter is that we’re still at a point right now where the yields on Treasury bonds just are not that high. So, it's kind of two sides of the same coin in terms of the argument. On the one hand the fear is, do I want to own U.S. Treasury bonds when people are worrying about them defaulting. The other side is, okay, even if you said yes, the problem is they’re not yielding enough anyway. So, put it in the way that big time managers like Bill Gross, and lot of these other folks, TCW/MetWest and others think about it: You're just not getting paid enough to take on those risks even if you aren’t worried about the U.S. defaulting.

So, a lot of bond funds that we cover, and managers that we respect are going outside of that. They’re minimizing their exposure to U.S. interest rates. They’re buying corporate bonds they think still offer some value. They still own some mortgages. And a lot of managers including PIMCO and others are going outside the U.S.--both developed-market sovereign debt and what we historically have thought as emerging markets--some of which are coming up into the realm of investment grade now. They have better finances than the U.S. has right now anyhow. So people are diversifying their portfolios in that way.

I would say be really careful about turning over that level of freedom and flexibility to managers that aren’t really proven yet and that maybe you don’t know that well--and that includes almost all of them, because even some of the best managers we cover don’t have a long track record of running in what we'd call "unconstrained" strategies. But it’s certainly something to think about. And even PIMCO Total Return, for example, which is not unconstrained in the sense that it still has the original interest rate requirements ... in terms of where its duration needs to be, Bill Gross has branched out pretty well in that, and already having more 15% roughly in non-U.S. assets. So, you’d be getting that even if you already still own a core bond fund.

Stipp: All right, Eric. Thanks for your insights on [Monday’s] news. It’s always a pleasure to talk to you. Thanks for calling in.

Jacobson: Glad to be with you Jason.

Stipp: For Morningstar, I’m Jason Stipp. Thanks for watching.