"At this point, we're more concerned about the risk of a downgrade than a default," said Terry Belton, global head of fixed income strategy at JPMorgan Chase. In a conference call with reporters Tuesday, Belton said the loss of the country's AAA rating may rattle markets, but it's "better than missing an interest payment."
Even with a deadline to raise the U.S. debt limit less than a week away, many investors still believe Washington will pull off a last-minute deal to avoid a catastrophic default. Washington has until Aug. 2 to raise the country's $14.3 trillion borrowing limit or risk missing a payment on its debt. President Barack Obama and Congressional Republicans have failed to reach an agreement to raise the debt ceiling and pass a larger budget-cutting package. Politicians have tied raising the debt limit and spending cuts together.
But at least one credit rating agency has already made it clear that unless that agreement includes at least $4 trillion in budget cuts over the next decade, the country's AAA rating could be lost. Right now, the proposals under discussion cut around $2 trillion or less.
Standard & Poor's warned earlier this month that there was a 50-50 chance of a downgrade, if Congress and President Obama failed to find a "credible solution to the rising U.S. government debt burden." S&P said it may cut the U.S. rating to AA within 90 days. Passing a $4 trillion agreement could prevent a downgrade, S&P said.
The other chief rating agency, Moody's Investors Service, said the U.S. government would likely keep its top rating if it avoids a default.
Spokesmen from both Moody's and S&P said they wouldn't comment beyond their recent reports.
Belton estimates that borrowing costs would rise between 0.60 to 0.70 points. That may not sound like much. But mortgage interest rates, which have hovered around 4.5 percent for the last several weeks, could rise by at least that amount, to more than 5.1 percent.
And for the federal government, it eventually means an extra $100 billion in interest payments to Treasury holders like China each year.
"That's a huge number," Belton said. That $100 billion a year that could be spent elsewhere on everything from education to infrastructure.
An increase in interest rates could soon become a drag on other parts of the economy, experts say. State governments and insurance agencies would also be downgraded — and states are already having financial troubles. Business confidence could sink again, leading to prolonged high unemployment.
But some investors aren't unhappy about the thought of a U.S. debt downgrade. Don Quigley, manager of the $1.5 billion Artio Total Return Bond fund reasons that such a move could provide a buying opportunity. He believes that a downgrade would immediately send the yield of the 10-year bond up to 3.15 percent from its current level of about 3 percent.
If the economy sinks further in part because of higher interest rates, investors would very likely return to buying bonds, Quigley said. That's what they've done during the last several years both during the financial crisis and recession, and again the last several months as the economic recovery has slowed.
Treasurys would keep their allure, in part, because there are few alternatives for large foreign buyers looking for a market big enough to handle massive investments.
"The German market is not big enough and Japan has its own problems," Quigley said.
A cut to the U.S. credit rating could hit stocks harder than bonds. A study by Janney Montgomery Scott looked at rating changes to countries over the past decade. After Spain was downgraded in 2009, Spain's stock market fell 8 percent in three months. A cut to Japan's credit rating in 2011 knocked the country's stock market down 3.4 percent in three months. The study, released in April, suggested the S&P 500 would fall 6% after a U.S. downgrade, erasing all its gains for the year.