What A U.S. Debt Downgrade Could Mean for Your Mutual Funds

FROM MARKETSCOPE ADVISOR TRENDS & IDEAS

TODD ROSENBLUTH, S&P Mutual Fund Analyst

As the Obama Administration and Congressional leadership in both parties  continue to struggle  over raising the government's debt ceiling, the potential moves by agencies such as Standard & Poor's Ratings Services have increasingly come in  focus.  While S&P Equity Research operates independently of S&P Ratings Services, we use their published research to support our holdings- based mutual fund ranking methodology, which is available on MarketScope Advisor. Let's take a closer look at how credit ratings impact the risk considerations of a mutual fund. 

S&P Ratings has published that "the reverberations of the showdown may be deep and wide - particularly if Washington does not come to a timely agreement on the debt ceiling." On July 14, Standard & Poor's placed its 'AAA' long-term and 'A-1+' short-term sovereign credit ratings on the United States of America on CreditWatch with negative implications, reflecting the view of two issues: the failure to date to raise the debt ceiling so as to ensure that the federal government will be able to make scheduled payments on its debt, and S&P's growing concerns about the likelihood that Washington will agree upon a credible, medium-term fiscal consolidation plan in the foreseeable future. 


S&P previously stated a belief that there is a material risk that efforts to reduce future budget deficits will fall short of the targets set by Congressional leaders and the Administration. In this light, S&P Ratings sees at least a one-in-two likelihood that they could lower the long-term rating by one or more notches on the U.S. within the next three months and potentially as soon as early August-into the 'AA' category-if S&P concludes that Washington hasn't reached what they consider to be a credible agreement to address future budget deficits.

In ranking taxable fixed income mutual funds, S&P Equity Research evaluates the weighted average Credit Rating of the underlying holdings of a mutual fund and compares this with other taxable funds. The S&P fund rankings uses the published credit ratings from S&P, Fitch, and Moody's to help us analyze the risk  considerations of a mutual fund and together with the duration (interest rate sensitivity) of the portfolio is partially balanced out by the 30-day SEC yield of the mutual fund. If the average credit ratings of the underlying holdings worsen, from AA to A for example, we consider the mutual fund to be incurring more credit risk, which might negatively impact the risk considerations score of the fund. 


But before you assume this potential downgrade would result in a quantitatively derived mutual fund ranking change, there are  few things to note. One, this level of credit risk might not be greater than that of other funds. It is important to keep in mind that S&P Equity Research ranks funds relative to one another, not in a vacuum. Two, fund management might decide to shift to shorter duration bonds to offset some of that risk. Three, typically bond holdings that are rated AA from a major agency will offer more yield than those rated AAA, possibly helping the performance analytics portion of the ranking model.

In a previous Trends & Ideas article titled, What the Debt Ceiling Talks Mean for Fund Investors, we  highlighted the importance of knowing how much exposure your portfolio has to Treasuries compared to corporate bonds, particularly when the fund's investment style offers flexibility. Below we list the largest mutual funds that we have research on, which are classified by S&P as U.S. Government Securities Funds and that are open to new retail investors, as these could be negatively impacted by actions taken by ratings agencies in coming weeks. Each of these share classes recently had more than $3.5 billion of assets.

JP Morgan Core Bond Fund (PGBOX 12 *****)

This S&P five-star ranked fund currently receives a positive risk considerations score, according to our research, helped by the strong credit ratings of the underlying holdings and the fund's relatively low standard deviation, a metric used to judge volatility. As of May 2011, 43% of assets were in mortgage  bonds, 26% were in U.S. Government bonds and 15% were in corporate bonds. The fund's 30-day SEC yield was 2.9%.

Fidelity Government Income Fund (FGOVX 11 ****)

This S&P four-star ranked fund currently has a neutral risk considerations score as the fund incurs less  modest volatility than peers, which partially counterbalances the strong credit ratings of the holdings. As  of May 2011, the fund had 43% of assets in U.S. government securities, 11% in mortgages and 10% in   agency bonds; the fund also makes use of derivatives. The fund's 30-day SEC yield was 1.8%.

American Funds US Government Securities Fund (AMUSX 14 ****) 

This S&P four-star ranked fund receives a positive risk considerations rank, as both the credit ratings and the overall duration contribute favorably. As of March 2011 (latest available), 40% of the portfolio was in U.S. Government bonds, 33% was in mortgages, and 23% was in Agency bonds.  The fund's recent 30-day SEC yield was 1.6%.

If the U.S. fails to make scheduled payments, or fails to reach a credible agreement to address future budget deficits, according to rating agencies, taxable mutual funds that invest in U.S. government bonds could incur more risk for their shareholders. To better understand what level of risk your mutual fund may currently have, please visit the Funds tab on MarketScope Advisor.

Note: The fund rankings in this article - from five star (highest) to one star (lowest) - are quantitatively derived from performance, holdings, risk and expense analysis. S&P Equity Research's stock rankings or STARS - using a scale of 5-STARS (Strong Buy) to 1-STARS (Strong Sell) - are based on S&P equity analysts' qualitative and fundamentally driven outlooks for stocks over the next 12 months.

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