Just out from Moody's
Potential Outcomes in Review of US Aaa Rating
Potential Outcomes in Review of US Aaa RatingSummary
The prolonged debt ceiling deliberations have increased the possibility of a rating change or outlook change, or both for the United States government's Aaa government bond rating. Nevertheless, it remains our expectation that the government will continue with timely debt service, and that our review for downgrade will more likely than not conclude with a confirmation of the Aaa rating, albeit with a shift to a negative outlook. However, if there were a default on a Treasury debt obligation, a downgrade would likely follow, even if the default were swiftly cured and investors suffered no permanent losses.
Announced July 13, our review was undertaken because of the small-but-rising probability that the Treasury would default on its market debt sometime after August 2 if the ceiling was not raised. The review will conclude when the debt limit is extended for more than a short period of time. Even a short-lived debt default, however, will likely prompt a downgrade. For Moody's, a debt default occurs only when an interest or principal payment on a Treasury security is missed, and does not arise when payment are delayed on other obligations such as federal employee salaries, Social Security, or vender bills.
If the debt limit is not raised before August 2, we believe that the Treasury would give priority to debt service payments and could thus postpone a potential debt default for a number of days. Revenues would be more than adequate for some period of time to meet those payments, although other outlays would be severely reduced as a result.
As to the longer-term outlook on the rating, the limited magnitude of current deficit reduction proposals suggest that even a timely increase in the debt ceiling will lead to the assignment of a negative outlook on the rating. The direction of the US government's debt rating will largely be determined over time by our projections of its deficits and stock of debt, but the focus of our current review for downgrade is the more narrow and more immediate "event risk" associated with a possible debt-ceiling-induced default and the precedent that such a default would carry. We will make an assessment of the government's efforts to stabilize the future path of its debt ratios when the review is concluded.
This issuer comment details how upcoming events may impact our review of and outlook on the US sovereign rating and discusses potential outcomes.
The Review for Downgrade
On July 13 Moody's placed the Aaa US government bond rating on review for possible downgrade because of the small but rising probability that the government would default on its debt sometime after August 2 if the debt limit is not raised. August 2, the date after which the Treasury estimates it will not be able to meet all its obligations, is approaching. Whether this occurs exactly on August 2 or on another date is not certain. Each day that passes without resolution of this issue raises the probability of default, but it is still our expectation that the government will continue with timely debt service on Treasury securities.
The review for downgrade will be concluded when one of two events occurs: (1) a default on debt obligations, resulting in a downgrade, or (2) an increase in the debt limit sufficient to last more than a short period of time, in which case the Aaa rating will likely be confirmed. The review was prompted by the possibility of default in the short term and is not directly related to the arguably more significant long-term fiscal and debt outlook. Therefore, Moody's will conclude the review when the short-term issue is resolved but also assess the government's efforts to stabilize the future path of its debt ratios. The rating may remain under review if there's only a short-term extension of the debt ceiling.
Event 1: The Government Defaults on Debt Obligations What would Moody's consider a default? We do not consider delayed payments for obligations other than debt service to be a default. The government will have to cut its spending by more than 40% after August 2 without an increase in the debt limit, since that is the proportion of spending that has been financed by debt issuance. To do so, it may delay payments for different kinds of obligations, such as the salaries of government employees, Social Security and Medicare payments, payments to companies that have contracts with the government, or debt service.
Governments from time to time make late payments to suppliers, for example, but Moody's does not consider that they have defaulted. Only if such payment arrears become substantial and appear to indicate a solvency problem would they have rating implications. In the present US case, the rise in payment arrears would simply be a substitute for the rise in public debt that would have normally occurred in the absence of the temporary constraint caused by the debt limit and, therefore, have no immediate credit implications. A missed interest or principal payment on a Treasury security, on the other hand, would constitute a default. If this were to occur, which we still consider unlikely, the rating would be downgraded. One scenario would be a downgrade by one notch to Aa1 immediately, with the rating remaining on review for possible further downgrade.
A one-notch downgrade prior to the expected resolution of the default would reflect our view that, even if interest payments were resumed quickly, a return to Aaa in the near future would be unlikely.
After August 2, the first interest payment date on Treasury bonds and notes is August 15, when $31 billion in interest is due. This is the first date that a default on bonds could occur. Based on the well-established monthly pattern of government revenue inflows and the scheduled interest payments on bonds and notes in coming months, the ratio of interest payments to incoming revenues can be calculated. August is one of the months when this ratio is highest during the current year, with interest payments being equivalent to about 20% of estimated revenues. In the following two months, this ratio is much lower. As a result, paying interest in August would potentially be more difficult than in other months, but it is important to note that incoming revenues are substantially higher than payments for interest alone.
In theory, a default could also occur on principal if maturing issues of Treasury bonds, notes, or T-bills could not be refinanced. Such an unlikely scenario would assume that there were no buyers for the new instruments when outstanding issues came due. The first T-bill maturity date after August 2 is August 4, when $59 billion in T-bills mature. Should the Treasury be unable to find buyers for an equivalent amount, a default might occur. This scenario seems extremely unlikely, given the role of the T-bill market in both domestic and global financial markets. It is worth noting that the debt limit was reached on May 16, and the Treasury has had no problem refinancing its maturing debt until now.