ETF Strategies to Follow on Moody's Downgrade of U.S. Debt

Moody's has downgraded the U.S. sovereign credit rating by one notch, citing concerns over the country’s ballooning $36 trillion debt burden. This move, following similar actions by Fitch in 2023 and S&P in 2011, raised alarm among investors about the nation's long-term fiscal sustainability.

Bond Market on Alert

The downgrade has veered the market’s focus toward Washington's fiscal policy debates. Carol Schleif of BMO Private Wealth noted that the bond market is closely watching developments in Congress, particularly as lawmakers debate a major tax bill backed by President Donald Trump and House Speaker Mike Johnson, as quoted on Yahoo Finance.

Moody's expressed skepticism over current fiscal proposals, stating these proposals are unlikely to materially reduce deficits. Rising 10-year Treasury term premiums suggest that markets are pricing in greater long-term fiscal risk.

Note that Term Premium on a 10 Year Zero Coupon Bond rose from negative 0.5593 in May 2020 to 0.5503 in May 2025. Meanwhile, the 30-year U.S. treasury yield jumped to 4.92% on May 19, 2025 from 4.89% recorded the day before.

Tax Bill Uncertainty and Market Reaction

Despite internal Republican disputes, Trump’s expansive tax-cut bill recently passed a key congressional committee. Still, market uncertainty looms over its final shape. After all, uncontrolled spending could deter investors from long-term Treasuries.

The Committee for a Responsible Federal Budget estimates that the tax bill could raise national debt by up to $5.2 trillion by 2034 if temporary measures become permanent.

Barclays Offers a Rosier Outlook

Barclays analysts suggested that the tax plan might be less damaging than previously thought. They estimate the fiscal cost to rise by $2 trillion over the next decade — less than the prior projections of $3.8 trillion, as quoted on Yahoo Finance.

Cost of Borrowing Likely to Rise

However, like many analysts, we believe that the debt downgrade could eventually lead to higher borrowing costs for both public and private entities.

Treasury Secretary Scott Bessent emphasized efforts to keep 10-year yields under control. Meanwhile, the White House dismissed the Moody’s downgrade as politically motivated.

Suggested ETF Investment Strategies

Given this volatile fiscal backdrop and market response, here are a few exchange-traded fund (ETF) strategies for investors:

Defensive Fixed Income Exposure

Short-Term Treasuries: Limit duration risk amid rising yields. Moreover, The ETF VGSH yields as high as 4.18% annually.

Diversification with Investment-Grade Corporate Bonds

Investment Grade Corporate Bonds: Potentially safer than Treasuries as yields rise. The ETF LQD yields 4.48% annually.

International and Global Diversification

Global Bond ETFs (e.g., BNDX, IGOV): Reduce U.S. exposure by incorporating non-dollar-denominated bonds. The ETF BNDX yields 4.29% annually.

Emerging Market Bonds (e.g., EMB): Emerging market bonds are higher-yielding, but come with higher risk. The ETF EMB yields 5.26% annually.

Tactical Plays on Rising Yields

Inverse Bond ETFs: Profit from rising long-term yields by investing in ETFs like TBT due to fiscal concerns.

Floating Rate Bond ETFs (e.g., FLOT, FLRN): Adjust coupon payments with interest rates, reducing duration risk. The ETF FLOT yields 5.43% annually while FLRN yields 5.42% (read: ETF Strategies to Play Amid Rising Treasury Yields).

Equity Market Protection

Dividend-Paying Equity ETFs: Stability and income during bond market volatility. Seek exposure to dividend-focused ETFs like VYM and SCHD (read: 5 Dividend ETFs Surviving the Tariff Turmoil Past Month).

Low Volatility Equity ETFs: Cushion against equity market swings linked to fiscal instability. Try ETFs like SPLV and USMV.

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This article originally published on Zacks Investment Research (zacks.com).

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