Bond rates: how S&P outlook will affect the market

WASHINGTON (MCT) — A surprise warning about U.S. debt by credit rating agency Standard & Poor's sent stocks plunging Monday and crystallized the threat that mounting federal budget deficits and national debt pose to the U.S. financial system and the American way of life.

S&P maintained the coveted AAA rating on U.S. government debt, but switched its outlook from stable to negative, a sign that the ratings agency has doubts about Washington's prospects for taking effective action to curb deficits and debt.

"The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years," S&P analysts noted in their credit report. "The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012."

The surprise action, considered belated by many financial analysts, raises the prospect that the United States could be deemed less creditworthy, which would raise the cost of borrowing for government, business and taxpayers alike.

Stocks fell sharply on the S&P report, with the Dow Jones industrial Average losing nearly 250 points in early trading before recovering to close down 140 points at 12201.59. The S&P 500 was down 14.54 points to 1305.14, and the Nasdaq fell 29.27 points to 2735.38. All three indexes fell about 1.1 percent.

Here's a deeper look at what this is all about.

Question: What is Standard & Poor's, and why does its opinion matter?

Answer: S&P is a nationally recognized statistical rating organization. It rates debt, in this case U.S. Treasury bonds, in terms of the risk of default they pose to investors in them. U.S. government securities have long enjoyed the top AAA rating but are now viewed as at risk for a downgrade of creditworthiness.

Q: Why would a downgrade affect borrowing costs in the economy?

A: The ratings issued by S&P and its main competitors — Moody's Investors Service and Fitch Ratings — are used by investors to calculate what sort of return they should demand in exchange for the default risk they assume when investing in a given security. A lower rating means a higher chance of default.

The issuer, in this case the U.S. government, would have to pay a higher interest rate to investors to market its lower-rated bonds. Since the government must borrow to pay off existing debt, the cost of that would snowball into an even more costly fix for our fiscal problems.

Q: How would that affect me?

A: Mortgage interest rates are often pegged to prevailing rates for U.S. government securities, as are other borrowing rates. If your 401(k) retirement plan invests in bonds, you might get returns from rising bond rates. This was reflected in the marketplace on Monday as the interest rate on bonds crept up and stocks lost value.

But rising borrowing rates choke off economic growth. If there's no political compromise in Washington on taming future deficits, that would be bad for the U.S. economy. And if there is a compromise, it is likely to entail austerity measures that slow economic growth.

Q: But lawmakers will reach agreement eventually, won't they?

A: The two political parties are very far apart. Their differences are rooted in deep philosophical disputes over the role of government in society. It's quite possible there will be no significant deal on resolving federal finances until after the 2012 elections, and then only if one side gains significant strength.

S&P analysts pointed to ongoing fiscal austerity efforts in France and Great Britain and questioned the lack of similar government financial discipline in the United States.

"We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation does not begin by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer 'AAA'" nations, S&P analysts wrote Monday.

Q: Was the S&P action totally a surprise?

A: No. In February, PIMCO, the world's largest bond investment fund, announced it was selling off its U.S. government debt because it didn't think the return on investment properly reflected the risks of holding U.S. debt. Earlier this month, PIMCO began actually betting against U.S. debt. In a sense, big players in the bond market got ahead of the ratings agencies, which they depend on for guidance.

S&P "should have made this move a long time ago," said Steven Ricchiuto, the chief economist for Mizuho Securities USA in New York. "Let's be honest. Ireland, Portugal, the (debt) issues of Spain are nothing more than a warm-up for what's in play here ... if something doesn't happen, it's going to be 'how many warnings do you have to send somebody before they pay attention.'"

Q: How big are our deficits and debt?

A: The nation's debt held by the public on Monday totaled $9.67 trillion, while the debt the federal government owes itself stands about $4.6 trillion. The total public debt outstanding stood at $14.3 trillion. The deficit — the shortfall between what government collects in revenues and what it spends in a given year — is projected to come in around $1.6 trillion for the current fiscal year, which ends on Sept. 30.

Q: What are the prospects for a budget deal?

A: The first real indication may come next month, when the U.S. likely will reach its current $14.3 trillion debt limit. Congress must raise the legal limit on how much the U.S. can borrow, and unless it does so, the U.S. won't be able to pay its creditors. That would sow financial chaos worldwide, as U.S. bonds are globally regarded as one of the world's safest investments.

David Lightman and Steven Thomma of the McClatchy Washington Bureau contributed to this article.