Downgrade in U.S. Debt Rating Could Have Grim Consequences

Editor's Note: This story has been updated since its original publication in the July issue of Kiplinger's Personal Finance magazine.

What if the unthinkable happens and U.S. government debt loses its coveted triple-A rating? After all, we're running trillion-dollar deficits without a plan in place to close the gap, entitlement spending is surging, and interest payments, much of it to foreign creditors, will balloon as rates rise. Voters say they want deficit reduction, but they also want low taxes and generally oppose cuts to expensive programs such as Medicare and Social Security. Of course, it's always possible that Congress will demonstrate courage, statesmanship and bipartisanship and agree on a dramatic budget deal. But how likely is that?

The effects of a downgrade could be dramatic. Stock markets could tumble, as they did briefly on April 18, when Standard & Poor's suggested that it might downgrade the U.S.'s debt rating (Moody’s Investors Service issued a similar waning on June 2). Interest rates would rise, both for government debt (ours and that of foreign countries) and for corporate bonds, which are generally priced in relation to Treasury yields. Bond prices, which move in the opposite direction of yields, would fall. In fact, a downgrade could negatively affect the prices of most assets, because financial models used to value everything from stocks to commodities and real estate use Treasuries as a proxy for the so-called risk-free rate of return. Downgraded Treasuries would no longer be seen as "risk-free."

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Ironically, the health of corporate America is improving as the finances of U.S., European and Japanese governments deteriorate. "The balance sheets of U.S. multinationals are stronger than those of many governments," says Noah Blackstein, manager of Dynamic U.S. Growth Fund. "Fundamentally, corporations seem like much better investments than governments."