FBY: Tax-Efficient Income But Risky At This Level (Rating Downgrade)

The recent Moody's downgrade of U.S. sovereign debt to Aa1—a symbolic end to the era of American fiscal exceptionalism—has profound implications for fixed-income investors. While Treasury yields briefly spiked after the May 16, 2025, announcement, the broader market shrugged off the downgrade, mistaking stability for safety. For income-focused strategies like the Fidelity U.S. High Income Fund (FBY), which relies heavily on tax-advantaged debt instruments, the risks are now sharply elevated. Here's why investors must rebalance portfolios to avoid fiscal fallout.

The Downgrade: A Watershed Moment for Fiscal Credibility

Moody's decision to strip the U.S. of its Aaa rating marks a stark acknowledgment of structural fiscal rot. With national debt hitting $36.22 trillion (124% of GDP) in 2025—the highest since WWII—the U.S. now faces interest payments projected to exceed $1.8 trillion annually by 2035. These costs will crowd out spending on defense, education, and infrastructure, while interest alone could consume nearly 7% of GDP by 2055.

The downgrade also exposes geopolitical vulnerabilities. The U.S. now relies on foreign sovereign wealth funds (SWFs)—notably from Gulf nations—to finance its deficits. Recent policy shifts, such as easing AI chip exports to the UAE alongside multibillion-dollar investments, underscore how fiscal fragility can compromise strategic autonomy.

Risks for Income Investors: FBY's Double Exposure

Funds like FBY, which blend high-yield corporate bonds and municipal securities, are inherently tied to Treasury yields and the U.S. fiscal outlook. Three risks now loom large:

1. Interest Rate Volatility: While Treasury yields have stabilized since the downgrade, the 10-year note is still near 4.4%, and the yield curve remains inverted (see below). This environment pressures bond prices and erodes income predictability.

2. Credit Quality Concerns: The sovereign ceiling rule—the principle that no corporate borrower can be rated higher than their country—suggests U.S. corporates could face rating pressures. Even if corporate bonds remain stable, the halo of Treasury risk now taints the entire market.

3. Geopolitical Leverage: SWFs holding $3 trillion in U.S. debt could demand concessions on trade, technology, or defense policies. This introduces political risk into fixed-income portfolios, which FBY's mandate doesn't account for.

Mitigating Risk: Rebalance Toward Diversification and Resilience

To navigate this environment, investors should:

1. Prioritize Inflation-Linked Bonds: Treasury Inflation-Protected Securities (TIPS) or high-quality corporate inflation bonds offer protection against the Fed's hawkish stance. The Fed's June 2025 decision to hold rates steady (despite cooling inflation) signals a prolonged period of elevated yields.

1. Shift to High-Quality Corporates: Firms with strong balance sheets, such as utilities or consumer staples giants, offer superior credit profiles compared to overleveraged issuers. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has outperformed FBY by 2.5% YTD.

2. Go Global: International bonds, particularly in AAA-rated nations like Germany or Canada, provide diversification. The iShares JPMorgan USD Emerging Markets Bond ETF (EMB) offers higher yields with exposure to faster-growing economies.

The Bottom Line: FBY's Tax Benefits No Longer Outweigh the Risks

While FBY's focus on tax-advantaged income remains appealing, its reliance on U.S. fiscal stability is now a liability. The Moody's downgrade signals that Treasuries—and by extension, funds exposed to them—are no longer “risk-free.” Investors chasing yield should pivot to inflation-protected instruments, high-quality corporates, or global bonds to insulate portfolios from the cascading fallout of U.S. fiscal fragility.

The era of free fiscal lunches is over. Prudent income strategies must now price in the cost of America's debt addiction.

Final Note: Consider consulting a financial advisor before making significant portfolio shifts. Past performance does not guarantee future results.