At the time of writing this article debt issued by the United States Government has been downgraded by Standard and Poors (S&P) from AAA to AA+. The reasons S&P gave for the downgraded are as follows:

1 “The fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what would be necessary to stabilize the government’s medium-term debt dynamics”.

2 “……the effectiveness, stability, and predictability of American policymaking and political institutions have weakened….to a degree more than was envisioned when we assigned a negative outlook to the rating on April 8, 2011”.

3 “Since April 8, 2011 we have changed our views on the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us, pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement into a broader fiscal consolidation plan that stabilizes the government debt dynamics anytime soon”.

Of the three items listed above, two of them pertain to the political atmosphere in the United States. It is fair to conclude that a large reason for the downgrade was the existing political rivalry between the Democrats and the Republican Party as opposed to the reduced capacity of the United States Government to continue to repay its debt. This perceived political instability is a result of the dispute between the Administration and Congress over the decision to increase the debt ceiling to meet the August 2, 2011 deadline.

The Anomalies

The sentiments and reactions, to the downgrade have varied. While the Dow has been plummeting, the 10 year United States Treasury (UST) yield has rallied over 400 points from a price of 104 to 108 or from a yield of 2.56% to 2.10% at the time of writing. In other words, investor demand for the recently downgraded US Government debt has risen but the demand for US stocks has fallen. This is absolutely bizarre and implies that the US Government is still viewed as a pillar of stability. It constitutes a classic example of the traditional risk off trade. A “risk off trade” simply describes a trade which aims to minimize risk.

However while the “risk-free” bonds have been rallying, yields on bonds categorized as “risk-on” have been widening or experiencing price declines. In sum, despite the credit rating downgrade of the US Government, investors still their view debt as a safe haven. One of the key questions to ask ourselves is if the UST’s yield is still the risk free rate by which all other US dollar credits in the investment space are judged? The behavior of the market seems to suggest that this is still so.

Further compounding this anomaly is the fact that some corporate credits are now ranked above their sovereign credits. As a result of the US Government downgrade, all credits with direct or implied guarantee of the US Government have also been downgraded such as Fannie Mae, Freddie Mac, FHLB etc. Consequently, there are now corporate bonds in the US that have higher credit ratings than the US Government itself e.g Microsoft, Johnson and Johnson and XTO Energy Inc. This is an anomaly indeed and defies the logic that the sovereign credit rating normally provides a ceiling for the credit rating of the corporate entities in the country. These are early days yet and we will continue to see more ripples as the downgrade works itself through the system.

Closer to home, all of the bonds in Jamaica and the Emerging markets have weakened significantly on the speculation that the US markets will remain weak for a while and as such will have negative effects on production/commerce with the rest of the world.

The Implications

Since the downgrade, the United States Federal Reserve has announced that interest rates in the US will remain low or near zero until mid 2013 as the US recovery is weaker than they had anticipated.

Low short term interest rates create the perfect opportunity for investors to realize gains by “rolling down the yield curve”. Rolling down the yield curve is a strategy that aims to take advantage of the difference between long term and short term interest rates. This strategy involves the purchase of longer dated securities that provide higher yields than current short-term securities. As the bond gets closer to maturity, assuming interest rates continue to fall, the price of the bond will rise. In sum, if interest rates are falling, investors holding medium to long term debt will experience higher capital gains than investors holding liquid short term securities.

Another opportunity is to look at assets/bonds that have experienced price declines due to sell offs but still have strong fundamentals. Look at purchasing such assets and possibly using some amount of leverage as you are now certain that rates will remain low for the next 2 years.

These are just some of the opportunities and by no means exhaustive, arising from the current uncertainty in the markets

Dave Cameron is the Manager of Fixed Income and Securities Trading at Sterling Asset Management. Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm