Moody’s U.S. debt downgrade — Investor implications

• The Moody’s credit rating downgrade of U.S. debt confirms that fiscal health issues remain significant.
• Debates around fiscal policies are set to intensify over the next 3 months, especially as Congress attempts to reconcile the budget, extend tax cuts and increase the debt ceiling.

• The U.S. Treasury market remains the largest and most liquid in the world, and we anticipate no imminent change to the importance of the U.S. Treasury market to global investors.

On May 16, 2025, the Moody’s global credit rating agency downgraded the U.S. government’s long-term debt from Aaa to Aa1, signaling that U.S. fiscal health remains on an unsustainable path. That new Moody’s rating is equivalent to the AA+ rating held by the other rating agencies, S&P and Fitch, following their downgrades in 2011 and 2023, respectively.

Moody’s cited the failure to increase revenue or structurally cut spending to slow the deterioration in debt affordability. In our view, financial markets have already priced in most of the rating downgrade, and this move just confirms that the fiscal deterioration issue remains significant. On a positive note, Moody’s believes that the U.S. retains strong economic fundamentals despite fiscal challenges, which allowed the rating agency to change its outlook from negative to stable.

Moody’s cited a sustained increase in government debt and interest payment ratios, which are now meaningfully higher than those of similarly rated sovereigns. Annual fiscal deficits are expected to remain large, driven mostly by rising interest payments, increasing entitlement spending (notably Social Security and Medicare), and relatively low revenue generation. Moody’s highlighted that successive administrations and Congress have failed to agree on measures to reverse these trends, pointing to decades of gridlock and political polarization.

Furthermore, the downgrade also reflects concerns about recent policy developments. In its statement, Moody’s specifically referenced the push to extend the 2017 tax cuts, which it said could add $4 trillion to the deficit over the next decade. Additionally, the rating agency expects growth to slow in the near term due to the Trump administration’s proposed tariffs but does not expect long-term economic growth to see significant impacts. Moody’s statement noted a “steady deterioration in standards of governance” over the past 20 years, eroding confidence in fiscal management.

While U.S. Treasury yields saw a modest uptick on the news, we believe that the bond market has already priced in most of the current fiscal challenges, and we expect limited additional market impact from the downgrade. The risk of a fiscal crisis appears to be low, in our view, but U.S. Treasury yields do include a yield premium to offset the perceived risks. We expect the impact on other U.S. fixed-income sectors to vary with the sector and its exposure to the federal budget and Treasury yields. However, as Treasury securities are the reference rates for most U.S. borrowing, the added pressure of higher yields could also elevate interest rates on consumer loans, including mortgages and credit cards, impacting households and businesses.

Globally, the downgrade may dent confidence in U.S. Treasuries, traditionally perceived as a safe-haven asset due to the U.S. dollar’s status as the global reserve currency. While demand for Treasuries is likely to remain strong, in our view, reduced foreign appetite — already evident following President Donald Trump’s tariff announcements — could exacerbate fiscal pressures.

Politically, the downgrade could be perceived as a setback for the Trump administration, intensifying debates over fiscal policy. The next three months will be key as Congress attempts to pass important bills around the budget, including extending tax cuts (and adding new ones) and passing an increase in the debt ceiling. The House Budget Committee advanced the administration’s budget bill on May 18. The full House is likely to approve the bill before it moves to a House-Senate conference committee to work out contentious differences with the Senate version.

The rating downgrade to the U.S. could also result in downgrades to government agencies and Federal Home Loan Banks. We do not expect other financial institutions to be impacted, except for certain senior debt and deposit ratings at the operating subsidiaries of systemic banks. Most bank debt is issued from bank holding companies, which would not likely benefit from any implied governmental support. The operating subsidiaries of the systemic banks (with one exception) have negative outlooks. Moody’s macro profile for the U.S. banking system remains Strong +.

For structured finance securities, we would not expect any impact on consumer asset-backed securities, commercial mortgage-backed securities, or non-agency mortgage-based securities (MBS). Separately, agency MBS, student loans, and Small Business Administration securitizations are not rated, so they would not have a direct ratings impact.

Corporate ratings at Aaa are not expected to be impacted by the sovereign downgrade — but currently, there are only two U.S.-based corporations with Aaa ratings. Higher education issuers that issue taxable bonds and receive significant government funding may see a ratings downgrade, however.

For municipal bonds, we believe pre-refunded and escrow-to-maturity bonds with Treasury or agency escrows will be directly impacted — with related downgrades. While these are narrow segments, they historically have been perceived as more stable investments, given the short maturity and highly rated escrowed asset.

The direct impact of the U.S. sovereign rating downgrade on the U.S. municipal market should be limited, in our opinion. However, federal funding is a critical component to revenues for some sectors. If a downgrade increases U.S. interest expense and increases federal budget gaps, federal funding could be at risk of reduction. While there are many variations within sectors, we believe the following highlights sectors most and least vulnerable to federal funding reductions. Pre-refunded with escrow-to-maturity, or agency-dependent, ratings, and housing deals wrapped by an agency security are vulnerable to ratings that fall in conjunction with the U.S. rating, in our view.

Federal operating and capital grants to U.S. states, cities, counties, essential service revenue, school district, higher education, and transportation (airport, mass transit, toll, port, and Grant Anticipation Revenue Vehicle, or GARVEE) are all vulnerable to federal funding reductions should the U.S. attempt to close budget gaps via spending cuts. Meanwhile, sectors such as dedicated tax revenues (for example, sales tax or hotel tax), land-secured bonds, and tobacco settlement bonds have minimal exposure to federal funding and therefore have the least direct impact from Moody’s action.

Uncertainty remains about how much and how quickly legislators can adjust fiscal policy, but our investment guidance routinely takes a diversified approach that includes a wide variety of securities and adjustments to changing opportunities. For example, while our fixed-income guidance utilizes investment-grade securities, including corporate and U.S. Treasury instruments, we currently favor corporates over Treasuries. We would not liquidate U.S. Treasury positions but prefer to add new cash first to investment-grade corporates.

Finally, we view the large size of the U.S. Treasury market and the U.S. dollar’s reserve currency status as good reasons to hold Treasuries, but our diversification strategy extends to managing duration risk. Specifically, while fiscal policy uncertainties continue, long-term yields are likely to be the most sensitive along the maturity spectrum. Against this risk, we prefer intermediate maturities (3- to 7-year notes), which we think provide attractive yields and reduce duration exposure. An investment professional can help investors identify their goals and risk tolerance and find an appropriate diversification strategy.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve.

Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.

Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate.

U.S. government securities are backed by the full faith and credit of the federal government as to payment of principal and interest. Unlike U.S. government securities, agency securities carry the implicit guarantee of the U.S. government but are not direct obligations. Payment of principal and interest is solely the obligation of the issuer. If sold prior to maturity, both types of debt securities are subject to market risk.

Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.

In addition to the risks associated with investing in international and emerging markets, sovereign debt involves the risk that the issuing entity may not be able or willing to repay principal and/or interest when due in accordance with the terms of the debt agreement.

In addition to the risks associated with investment in debt securities, a fund’s investments in mortgage-backed and asset-backed securities will be subject to prepayment, extension and call risks. Changes in prepayments may significantly affect yield, average life and expected maturity. Extension risk is the risk that rising interest rates will slow the rate at which mortgages are prepaid. Call risk is the risk that If called prior to maturity, similar yielding investments may not be available for the Fund to purchase. These risks may be heightened for longer maturity and duration securities.

Bank loans are subject to interest rate and credit risk. They are generally below investment grade and are subject to defaults and downgrades. These loans have the potential to hedge exposure to interest-rate risk but they also carry significant credit and call-risk. Call risk is the risk that the issuer will redeem the issue prior to maturity.

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Moody’s uses a lettering system consisting of upper and lower case, as well as numeric modifiers. 'Aaa' and 'Aa' (high credit quality) and 'A' and 'Baa' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('Ba', 'B', 'Caa', etc.) are considered low credit quality, and are commonly referred to as "junk bonds". The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category.

Standard & Poor's (S&P) and Fitch use upper-case letters to identify a bond's credit quality rating. 'AAA' and 'AA' (high credit quality) and 'A' and 'BBB' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('BB', 'B', 'CCC', etc.) are considered low credit quality, and are commonly referred to as "junk bonds". S&P ratings may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.

An index is unmanaged and not available for direct investment.

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