Rerating bonds

US rating downgrade: Standard & Poor's could cut America's AAA rating even if Congress does a deal on the debt ceiling. That would force a rethink. The 18 other top-rated sovereigns are either caught up in the EU mess or tiny. Without the ‘risk-free’ benchmark of US Treasuries, even ultra-cautious bond investors would have to get used to credit risk. The United States, $7.8 trillion of Treasury bonds, notes and inflation-protected securities in public hands, together with more than $5 trillion of federal housing agency paper and the debt of several insurance companies, would all be affected if America's rating slipped to AA, according to S&P.

For bond investors fixated on AAA credits, there is not much capacity elsewhere to pick up the slack. Other S&P top-rated sovereign entities include the Isle of Man, Guernsey and Liechtenstein, which are tiny. Even the largest of them, Germany, had only ¤2 trillion ($2.9 trillion) of public debt outstanding at the end of 2010. Moreover, six of the entities are euro zone members, and several others are closely connected to the EU’s debt troubles. Only Australia, Canada, Norway, Singapore and Switzerland hold top ratings without such blemishes, but all five have relatively small amounts of debt. Top-rated companies do exist, but in the United States, for instance, there are only four of them. That is nowhere near enough to absorb investor demand even assuming buyers could get used to relying on corporate rather than government credit.

Giant US money market funds - obliged to hold almost all their assets in AAA credits — might be spared a huge sell-off in a downgrade scenario because their rules refer to short-term ratings and S&P's threat might only apply longer-term. For other investors, adjusting portfolio holdings, and even their guiding rules, to include US and other AA-rated names should require only modest changes - though banks and some insurance companies might have to raise a bit more capital. And, the US government bond market would still be there, even if interest-rate comparisons with Treasury yields would have to contemplate negative numbers as well as positive. The biggest impact could be psychological: there would no longer be a globally accepted liquid benchmark viewed as ‘risk-free’. Fifty years of thinking, and computer models, would need tweaking.