Bottomline | Why US debt woes may be an opportunity

Global rating agency Moody's has changed its outlook on US sovereign debt to negative even as it has retained the top Aaa rating. The move suggests a step towards a downgrade if financial conditions don't improve. At the core of Moody's concerns is unbridled fiscal spending. "In the context of higher interest rates, without effective fiscal policy measures to reduce government spending or increase revenues, Moody's expects that the US' fiscal deficits will remain very large, significantly weakening debt affordability," the agency said.

It is important to note here that Moody's isn't the first to caution on the deterioration in US fiscal health. Fitch had in August cut its rating to AA+ from AAA. While a potential downgrade is a key risk to factor in for investors, and it could push yields higher to factor in the cut, it is unlikely to cause a significant stir for two reasons: first, much of the fiscal health has already been factored in by the markets, and second, US debt is still among the safest bets for large investments in the world.

Given this, let's look at what this development and the "higher for longer (rates)" stance of central banks can spell for investors.

Bond markets in the US, like any other, have had their share of tops and troughs. No market has a linear move, and this provides patient investors an opportunity for gains. Interest rates being higher for longer is good news for investors as it allows them more time to lock-in funds for the long term at higher yields.

A look at how the US market has behaved over the years suggests a sharp decline in yields after every top. The median and mean declines from tops to troughs since 1981 stand between 43% and 44.3%. Even the most recent three instances have seen drawdowns between 25% and 36.5%. These sharp moves present significant opportunities also for capital gains.

Here, the unprecedented rise in yields in the recent past needs to be appreciated. US bond yields have moved up from a low of 0.38% in 2018 to a high of 5% in October 2023—that's in just five years. In contrast, yields, after hitting a high of 7.9% in November 1994, dipped to a low of 2% in June 2008. That's a good thirteen-and-a-half years for a 6% move. And while we did see a big move from 15.8% in September 1981 to 10.2% in February 1983, in terms of percentage change, it is clearly dwarfed by the recent move to a high of 5%. What this suggests is that any correction of this unprecedented move, if and when it occurs, could be swift and big.

But the big question on everyone's mind is: Have interest rates peaked? The narrative on this is evolving even as I write this. From interest rates having topped out a week ago, there now seems to be some shift of bets towards another rate hike with a no interest rate cut but higher for longer narrative. But sift through the commentary, and what emerges is that most don't see interest rates heading much higher. For long-term investors, that's as good a cue as possible. Locking into higher rates by investing a part of your total allocation over the next 6 to 9 months could be a good approach.

There are two reasons for Indian investors to consider investing in overseas bonds. First, is the attractive returns they offer. The second, is the relative safety (academically in the short-term). Let’s look at this. On a plain reading, US bond yields on a 10-year security at near 4.7% would look unattractive vis-à-vis the near 7.3% on Indian Government securities of a similar tenure. However, for a fair comparison, the dollar-rupee factor must be brought into the equation. Over the past 20 years, the rupee has depreciated at a compounded 3% per year against the US dollar. If you add that to the US bond yield, the ultimate return climbs to 7.7%.

What's more, just like with any other debt instrument, investors should take note of the rating quality of the debt they are investing in. Here too, the US scores among the highest ratings in the world, despite recent concerns. Moody’s still retains an Aaa rating for the US, but ascribes a Baa3 rating to Indian sovereign debt. A look at the ratings snapshot below offers a perspective.

Here, it pays to mention that in the near term, barring any unforeseen, radical developments, for all practical purposes, US Government and Indian Government debt can be considered equally safe with respect to payment of interest and return of principal. Hence, a significantly lower rating alone should not prompt you to shift allocation from local bonds to overseas bonds.

For investors, the important point is that this could be a good time to invest in debt. But look for safe options rather than get drawn by mouth-watering yields, as high yields only come with higher risk. While the more informed could consider corporate debt as an option, for most investors, government securities are a better direct investment option. Investors can also look at gilt funds and debt funds with a healthy performance track record.

Happy investing!