The Downgrade And Bond ETFs

August 11, 2011

Last Friday, it happened – “The Downgrade.” There’s only one problem. It doesn’t really matter.

As many anticipated, Standard and Poor’s finally lowered the long-term credit rating of the U.S. from “AAA” to “AA+, ending all the speculation and unleashing a cause-and-effect torrent of downgrades that touched other parts of the U.S. government and even the world of ETFs.

For example, on Monday, S&P followed up with a downgrade of 73 funds. The action included ETFs from iShares and State Street Global Advisors. Interestingly, the list contains only 15 of 48 ETFs that have substantial exposure to U.S. Treasury and government agency bonds, and that’s because only funds that ETF companies request to receive financial credit quality ratings, or FCQRs, actually get them.

By the way the “f” in the actual ratings in the table below stands for fund.

But does it even matter?

I think not.

Whoever got downgraded, or never got rated at all, really doesn’t matter to investors, because these fund downgrades are really much ado about nothing.

The S&P decision is just one of three opinions.

So, investors in ETFs such as the iShares Barclays 1-3 Year Treasury Bond Fund (NYSEArca: SHY) and PIMCO 1-3 Year U.S. Treasury Index Fund (NYSEArca: TUZ) may be surprised to find out that, as far as their index providers are concerned, Treasurys are still rated “AAA.”

Indexers use credit ratings of underlying securities to classify debt issues as investment grade or high yield. They also use the ratings to determine inclusion in sub-indices.

But, crucially, index providers don’t use any one rating agency’s opinion on credit exclusively. Instead, they usually rely on some form of an average credit rating between Standard and Poor’s, Moody’s, and Fitch.

Barclays Capital, whose indexes are tracked by 62 of the 144 fixed income ETFs trading in the U.S., assigns issuer’s credit rating based on the middle rating among the three agencies — when all three issue a rating.

Bank of America Merrill Lynch, on the other hand, assigns a numeric value to each credit rating: “AAA” = 1, “AA+” =2 and so on. It then averages the three values and then converts back to a letter grade based on the same rubric.

In both cases, a downgrade from “AAA” by just S&P doesn’t precipitate a change in the credit rating. However, were the other shoe to drop and either of the other rating agencies would follow suit, it could force the indexer’s hand.

Although relatively obscure, this piece of the methodology, for now, allows for Treasurys and other agency debt to continue to maintain its “AAA” rating for indexing purposes. A reasonable argument can be made that this consensus opinion is as good as any.

“The Downgrade” came and went along with a slew of associated ratings adjustments. Although historically significant, it still remains just that, an opinion. And when combined with the current opinions of the rating agencies, it doesn’t change a thing.

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