What's Next? A Reverse Ratings Split?

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. 

"Just sittin' around drinkin' with the rest of the guys
Six rounds bought, and I bought five.
Spent the groceries and half the rent.
I lack fourteen dollars of having twenty-seven cents"
- Roger Miller 

With the news last week that Standard & Poor's put the United States of America on "negative outlook" regarding its AAA rating still lingering in the air, I'm wondering why this is so important.*

By definition, investing is a "relative" game. Like Roger Miller's creative lyric that he's only short 14 dollars from having 27 cents, is it more important that he is in the hole $13.73 or that he's down $14?

In the markets, depending on your investment objectives you take your money and put it in the best relative investment choice. But you must always adhere to your overriding investment objectives first, so your return will vary with the markets.
Consider your typical pension fund that is today getting whacked by low yields. Is their solution to take on more risk? Perhaps, but it should always work within their predefined investment set.

In other words, just because investing in death benefits can return 15-20 percent, it shouldn't shift funds into such illiquid, uncertain options in hopes of gaining higher yields (It can also return as low as 1-2 percent and leave your funds locked up for decades).

This is why investing with an achievable market-related benchmark in mind is so important.
Pension funds typically look to their fixed income managers to outperform the Lehman (I can't seem to get used to saying Barclay's) Aggregate Bond Index. When the yield curve is high, this index may pay around 6-8 percent. When it is low, like today, the average yield could be 3 percent. Like it or lump it, you cannot achieve a return that is not offered in the marketplace.

It could be that credit ratings are finally being revealed to have the same characteristic.

On Monday, when S&P made the negative outlook announcement, Treasury yields actually dropped and prices rose slightly. By S&P's definition, the outlook change means they are giving it a one-in-three chance that Uncle Sam gets downgraded sometime in the next two years.

The market did not react as you might expect given the news. But when you look at the action through the lens of relativity, it becomes quite understandable that investors would yawn at such news.

In the relative world, it seems S&P may only just now be bringing its outlook of the U.S. in line with the wave of downgrades felt across the spectrum of issuers over the last three years. In fact, if you consider the breadth and depth of markets along with trading volume and other liquidity measures, no market comes close to the U.S. in terms of realistically allocating the safer portion of your portfolio.

And that means it is still the safest place, by far, to store your wealth.

Given the market views credit ratings in terms of relative instead of absolute levels and given the USA will remain the most liquid, creditworthy market-place for bond investors, doesn't it seem more appropriate to peg them at AAA and rate every other issuer based on its safety relative to the USA?

The real problem here is that no one really knows what "AAA" means. It does not, and never has, meant that credit risk is zero (take a look at a multitude of AAA mortgage bonds in the post 2008 world for an eye-popping example).

But instead of clarifying what their ratings scales mean, the agencies are it seems erring on the conservative side by downwardly adjusting ratings across the board and, in the process, perpetuating the "absolute" view of their ratings scales. So, where does this end? Perhaps with the USA rated AA and all other issuers of any liquidity at some level lower.

At that point, I wonder if there will be an effective "reverse split" of the ratings scale, given the designation "AAA" has gone out of use? After all, if no one is rated AAA, AA becomes the new AAA, right?

*For an FAQ on this topic, please click here.