Fixed income, US economy Fitch downgrades GSEs to AA+

The GSEs' Rating Watch Negative, placed by Fitch during the debt-ceiling brinksmanship in May, was removed. Fitch stated that the decision comes because of the “implicit government support” from which the GSEs' benefit, and that “the Long-Term Issuer Default Ratings (IDR) of Fannie Mae and Freddie Mac are directly linked to the Long-Term IDR of the US sovereign and will continue to move in tandem.” It is important to note, however, that Fitch affirmed the downgrade was “not driven by fundamental credit, capital, or liquidity deteriorations,” and that Fannie and Freddie would still be able to “provide liquidity, stability, and affordability to the housing finance industry.”

Portfolios that maintain lower average ratings are more likely to see sell-offs in their lower-quality credit holdings to rebalance their own averages while they maintain their agency MBS positions despite the lower rating. While the one large buyer of MBS—the Federal Reserve—continues its quantitative tightening policy, the lower supply in the marketplace due to rising mortgage rates has been a needed offset. It is unclear what impacts the downgrade would have for foreign buyers. While US agency MBS, even at AA+, holds a higher credit rating than similar foreign debt, the downgrade and overall environment may give some foreign buyers pause, though we don’t believe this to be likely given that the risk base capital weightings have not been changed. And with higher yields, we anticipate foreign buying will continue as the economy slows over the next several months.

Current coupon spreads were already elevated, having been near BBB credit levels for several months now, and moved just 5 basis points higher after the downgrade, to 174bps from 169bps. Notably, this is still 20bps lower than the year’s high of 194bps seen at the end of May during the debt ceiling debate, when Fitch first put Fannie Mae and Freddie Mac on Rating Watch Negative. Even so, it is more likely that this slight widening is due to the overall rate environment and current volatility than a reaction to the downgrade itself. We maintain agency MBS as a most preferred allocation due to the relative value that can be found with current coupon yields and spreads at historical levels . Fitch’s downgrade does not change this view.

Overall, we believe the impacts of the downgrade will be muted, and the movement in the agency MBS market will be driven by the current environment as it relates to fundamentals and interest rate volatility, rather than a result of the ratings downgrade. As Fitch itself stated, the downgrade was a result of the inherent relationship between the GSEs and the US government and can be viewed as more of a comment on the current political climate than on the credit quality of Fannie Mae and Freddie Mac.

Main contributors - Leslie Falconio, John Murtagh

Original report - Fitch downgrades GSEs to AA+, 3 August 2023.