Does the US Debt Downgrade Matter for Investors?
Moody’s stripped the US of its last perfect credit rating as debt levels surge and fiscal gridlock persists. While short-term market volatility is possible, Treasury bonds remain strong and rising yields may create new opportunities for income-focused investors.
Key takeaways
The US government's credit rating has been lowered by ratings agency Moody's, years after other ratings firms made similar moves.
The downgrade reflects concerns about the growth of the government's debt and the ability of Congress and the administration to control spending.
Financial markets may experience short-term volatility as a result of the downgrade.
Bonds issued by the US Treasury remain among the safest investments despite the downgrade and Treasury yields may rise as a result.
Moody's Ratings, the last credit rating agency to give a top credit rating to bonds issued by the US Treasury, has joined its peers in moving its rating on government debt one notch lower, from Aaa to Aa1. The cut means Moody's now gives the US the same rating that S&P Global has maintained since 2011 and Fitch has since 2023.
The downgrade moves the US out of the group of countries that hold the world’s highest credit ratings from Moody's, which is one of 3 firms that evaluate the ability of governments and companies to pay back interest and principal to investors who lend them money by buying the bonds they issue.
This latest downgrade reflects the same concerns that inspired the 2 earlier ones: the growth of the national debt and the lack of progress toward reining in deficit spending.
What's behind the credit rating downgrade
The fact that the federal government has suffered a third debt downgrade 14 years after the first one and 2 years since the second suggests that Washington’s lack of resolve to meaningfully cut spending is an ongoing concern for ratings agencies and investors alike.
When the US's credit rating was first downgraded following the 2011 agreement to raise the debt ceiling, one of the reasons ratings agencies gave was the failure of politicians to confront rising debts. Not so long ago, members of both political parties expressed concern about the impacts of government debt and spending. Many Democrats as well as Republicans supported a constitutional amendment requiring a balanced budget and from 1998 to 2001, congressional Republicans and a Democrat president produced balanced federal budgets. But since then, deficit spending that increased borrowing makes possible has continued even in a highly polarized political environment.
Publicly held US debt topped 123% of gross domestic product in 2024, according to the US Office of Management and Budget. That's a level of debt far greater than the average over the past 50 years. And the debt is projected to increase significantly in the future. The Congressional Budget Office (CBO) projects the federal budget deficit will total $13.1 trillion through 2032. Currently, 18% of government revenue goes to pay interest on the national debt and Moody’s expects this to increase to 30% by 2035.
What may be next?
In the future, a lower credit rating could mean that the US government could have to pay higher interest rates on new debt that it issues. This could mean that a larger percentage of the US budget will be consumed by paying interest on the debt.
Lower confidence by investors in the government's ability to manage its finances could put continued downward pressure on the value of the US dollar, exacerbating a gap in performance between US and international stocks on a dollar basis.
The downgrade could also increase the chances of a steeper US Treasury yield curve if investors demand higher yields to invest in the US by demanding a premium for bonds that mature further into the future.
What may the credit rating downgrade mean for stocks?
Stock markets generally react over time to changes in the pace of economic growth, and the direction of corporate earnings and asset prices, rather than political events. The S&P and Fitch downgrades did not lead to sustained shifts in stock, bond or currency prices. A year after the 2011 downgrade, for instance, 10-year Treasury yields were lower and the dollar was higher, due to concerns about the European sovereign debt crisis, fiscal austerity, and potentially slower US economic growth. A year after the 2023 downgrade, 10-year Treasury yields and the dollar were largely unchanged while the S&P 500 was higher by nearly 20% in anticipation of stronger economic and earnings growth.
Still, while the market reaction may be muted, the debt downgrade highlights worries about the deficit/debt and the potentially unsustainable fiscal trajectory of the US.
What may the credit rating downgrade mean for bonds?
Despite the downgrade, the market for bonds issued by the US Treasury is still the largest and most liquid financial market in the world. The downgrade could deliver some opportunity for income-seeking investors by pushing up the yields on Treasury bonds with longer maturities. While the US remains the most liquid bond market by far, the downgrade could shift some capital toward the debt of other highly rated countries.
Fidelity’s fixed income macro analyst Kana Norimoto says, "Moody’s, as well as other rating agencies, still give credit to the US government’s institutional strength and constitutional separation of powers. This is a key feature that undergirds the US's’ still high ratings, despite the fiscal picture."
What can investors do about the debt?
Investors concerned that rising debt may cause higher volatility and lower growth in the future may want to consider further diversifying their portfolios by adding exposure to a wide variety of assets. These could include potentially higher allocations to international stocks, alternative investments, and high-quality bonds that offer attractive starting yields.