.Moody’s cut the U.S. sovereign rating from Aaa to Aa1 after market close on Friday, May 16. When markets reopened on Monday, May 19, equity indices rose despite the downgrade, although they weakened in subsequent sessions. By May 29, yields on U.S. 10-year Treasuries had returned close to levels seen at the start of the year.
Bond yields rose in the days following the downgrade, but that move was “muddled by the passage of a reconciliation bill in the House that potentially could add to the deficit in future years.” By May 29, Damodaran said, “almost all of the downgrade effect had faded, with rates close to where they were at the start of the year.”
Damodaran identified three key reasons why markets shrugged off the downgrade.
First, “while the timing of the Moody’s downgrade was unexpected, the downgrade itself was not surprising.” Moody’s had placed the U.S. sovereign rating on negative outlook in November 2023, and with S&P and Fitch having already downgraded the country, Moody’s Aaa rating had stood out as the anomaly. “It was only a matter of time before it joined the other two agencies.”
Damodaran said that “the immediate effect of a sovereign ratings downgrade is on government borrowing,” but highlighted that “private capital (in the form of equity and debt) is a far bigger source of financing and funding for the economy.” As such, a change in government creditworthiness has a more limited effect on overall capital market conditions in the U.S.
“The ratings downgrade was more of a blow to pride than to finances,” Damodaran said, noting that “the default risk (and default spread) difference between an Aaa rating and a
Aa1 rating is small.” He gave the example of Austria and Finland, both rated Aa1 in May 2025, whose 10-year euro-denominated bonds traded at a spread of about 0.15% to 0.20% over Germany’s Aaa-rated bonds.
While the downgrade has had little market impact, Damodaran said that it does carry implications for valuation and investment analysis. Specifically, analysts can no longer assume the U.S. 10-year treasury yield represents a risk-free rate in the strictest sense.
“In principle, the risk free rate is what you will earn on a guaranteed investment in a currency,” he wrote. To arrive at that rate in markets where sovereign bonds carry default risk, analysts typically net out a default spread from the government bond rate. “Now that the U.S. is no longer Aaa rated, we have to follow a similar process to get a risk free rate in U.S. dollars.”
On May 30, 2025, the 10-year U.S. treasury yield stood at 4.41%. Based on an Aa1 rating, Damodaran estimated a default spread of 0.40%, yielding an adjusted U.S. dollar risk-free rate of 4.01%. He noted that “U.S. treasury markets have been carrying a default spread embedded in them for years,” and the downgrade simply made that explicit.
Damodaran’s equity risk premium (ERP) model is also undergoing a recalibration in response to the downgrade. Previously, the ERP for the S&P 500 served as a benchmark for all mature markets rated Aaa. Countries with lower ratings were assigned a higher ERP based on their default spreads.
Following the downgrade, Damodaran said he will adjust this method in three ways: using the adjusted risk-free rate to calculate the U.S. ERP, assigning lower ERPs to Aaa-rated countries that are now deemed safer than the U.S., and basing other countries’ risk premiums on the ERP for Aaa-rated countries instead of the U.S.
On May 30, 2025, Damodaran estimated the expected return on the S&P 500 at 8.64%. Factoring in the downgrade, the composition of that return changes: “resulting in a lower risk free rate (4.01% instead of 4.41%) and a higher equity risk premium (4.63% instead of 4.23%).” The average cost of equity remains unchanged, but the mix shifts slightly, with safer firms seeing lower costs of equity, and riskier ones slightly higher.
“The effects are so small that investors will hardly notice,” Damodaran said. “Staying with the conventional approach (of using the ten-year U.S. treasury bond rate as the risk free rate and using that rate to compute the equity risk premium) will continue to work.”
“The downgrade's effects on the discount rates (costs of equity and capital) are minimal,” he said, and analysts can “continue to work with the U.S. treasury rate as a risk free rate and forward-looking equity risk premiums, as they did before the downgrade.”
However, Damodaran added that Moody's action carries symbolic weight: “Another indicator that U.S. exceptionalism, which allowed the U.S. to take economic and fiscal actions that would have brought blowback for other countries, especially in emerging markets, is coming to an end.”
“That is healthy, in the long term, for both the United States and the rest of the world, but it will come with short term pain,” he concluded.
Also read | 3 lessons valuations guru Aswath Damodaran learnt from April's wild market ride
(: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of the Economic Times)
