You’ve probably seen a version of this headline already. If not, here’s one from The Wallstreet Journal:
S&P removed for the first time the triple-A rating the U.S. has held for 70 years, saying the budget deal recently brokered in Washington didn’t do enough to address the gloomy long-term picture for America’s finances.
First, let me say that I am not concerned about how this will affect the portfolios that I manage for my clients.
Before I explain why, let’s define some terms.
What is a bond? Stocks and Bonds both give money to others for their use and bring a return to the one giving it. If you give your money in exchange for a stock share, then you are becoming an owner in that company and are entitled to the profits of that company as well. By the same token, if that company falls on hard times, you will be called on to share those losses from time to time. A Bond on the other hand is your money “lent” to a company (or another issuing entity). When you lend your money by purchasing a company’s bond, you will do so expecting to be paid interest. Bonds are “safer” than stocks because the debts of a company get paid before shareholders do.
With bonds, if you are looking to achieve a higher rate of interest as a “lender” or bond investor, what do you need to do? Well, higher reward requires higher risk, so you’ll need to lend to riskier borrowers or for a longer term. Both of these will increase your return/yield. That makes sense.
For example, to increase your return in bonds you could lend to a lower credit scored, or Bond Rated entity. You could also lend your money for Mortgage Backed Security rather than a 2-year Corporate Bond. Both of these kinds of lending increase your risk and thus increase your expected return, the interest paid to you. Again, this is called Bond Yield.
So, in the same way that an individual can mak late payments and see their credit score decline, a company or government can “default” on their debt by not paying the full amount or paying late and see their Bond Rating reduced. But in the same way that there are more criteria than just defaulting that can reduce an individual’s credit score, there are also more criteria that will sometimes reduce a company’s or government’s credit rating. One of these criteria is excess debt. Our country has just applied for and has been given an increase in their credit limit and the rating agencies don’t like it. It is my belief that the rating agencies wouldn’t have liked any of the solutions. We were already in too much debt. Be that as it may, our credit rating decline will increase our cost of borrowing. In otherwords, when the US government issues bonds to raise money to pay our bills, we will have to pay our lenders more interest.
The answer to correcting this (for what it’s worth), is not difficult. It’s the same for individuals, countries and companies. Borrow less. Pay off what you have borrowed. And live with in your means (I posted a quick conversation I had last week on that – you can read it here). If the kind of deal that has been struck in Washington does this, then I’m for it. We’ll see what the super duper committee of politicians can come up with as far as cuts, but I’m not holding my breath.
I started out by saying that I was not concerned about this from a portfolio perspective. Here’s why: In the 90s and early 2000s our mutual fund managers were approached by countless “long bond” fund managers asking us to add these long-term bonds (including mortgages) to our portfolios. They had been getting better yeilds by 2 and 3% over the short-term bonds that we had always used, and many other fund managers were moving to this product as way to boost returns. Would we consider using these products? We knew at least two things about long bonds, and we for sure know these two things now.
First, we know that long-term bonds are far riskier than short-term bonds. Compared to nearly 40 straight years of positive returns in our short-term bond fund, the long-term bonds have had much more volatility and have experienced nine negative return years during that same period. Secondly, we see little correlative benefit between stocks and long-term bonds, but we see huge correlative benefits between short-term bonds and stocks. In other words, short-term bonds move in almost the opposite direction as stocks. This is very valuable when stocks are coming down. While stocks decline, as they have in the past couple of months, we see gains in short-term bonds. We can then harvest short-bond gains to invest in devalued stocks. This formula is far too important to our investors to abandon for the fly-by-night (and undocumented) promise that long bonds would pay off with a little better return. Short-term bonds are called FIXED income for a reason.
So to wrap up, we are not concerned about the United States’ credit rating and our portfolios for a few reasons:
1. We don’t own risky bonds–only short-term positions of 1 to 5 years at the longest.
2. We know that any stock declines here in the US as the result of our reduced credit rating are temporary and the rebound will come in time.
3. In the mean time, we take advantage of declines in any asset class by selling fixed-income and purchasing more stocks on these dips.
4. We are globally diversified in nearly 20 distict asset classes in 44 countries owning nearly 13,000 companies worldwide.
The US will either pay its bills or it won’t, but my faith as an investor is not in the US government. We will pay the price for our desire to borrow rather than invest on a national level as we will as families. We can always be thankful for hard times in a way because they make us smarter and stronger and remind us of what we believe.
As an investor coach to over 100 families, I am putting their money and the promise of long-term returns in the hands of the market that has brought a greater than 10% return to its owners over the past 9 decades. Not fund managers, not rating agencies, not financial planners (even CFPs!).
The bonus for my clients in these times is that we are also able to make your portfolio stronger by rebalancing for more shares of the companies that will eventually take us out of this.
So, if you’re not lending your money for the long term, and you’re not borrowing money, you don’t need to worry too much about your credit score. Neither would the U.S. Lets stop borrowing and stop worring about our credit ratings. For debt-free investors, it’s a meaningless category.
Free Markets work.