Debt Ceiling Update

By Aradhana Kejriwal   |   July 27, 2011

Given the fluid and rapidly changing nature of the debt ceiling debate, we want to provide you with an update and our current thinking on this situation.

  • Despite ongoing political gamesmanship in the debt ceiling/budget negotiations, we believe our elected leaders will get their act together and we will NOT default on the national debt. Daily rhetoric from Congress suggests that these leaders understand the potential consequences and believe that defaulting on the US debt is not an option; however, this high-stakes game of “chicken” continues and the House remains far from securing enough votes to ensure passage of any of the options thus far presented.
  •  Virtually every major player in the debate seems to agree that a US debt default is unthinkable, and clearly, no one wants to risk taking the political hit for the financial chaos that might ensue if a default were to occur.  In our view, the possibility of an outright default remains extremely low and we expect to see at least some sort of short-term increase in the debt ceiling.  As we have stated in prior emails and blogs over the past few months, this process has not been and will not be an easy one, and we expect more twists and turns before this crisis comes to a conclusion.
  • We believe that the closer we get to the August 2nd deadline, the higher the likelihood of Congress passing a short-term patch deal as it would be extremely difficult to work out the specifics of a major spending reduction and/or tax overhaul plan at the last minute.  We believe the markets likely would respond negatively in the short run to such a tepid deficit reduction plan.
  • We believe that risks to the Treasury market could affect other areas of the bond market as well.

We reaffirm our belief that Congress will raise the debt ceiling rather than risk the potentially dire consequences of default.  If so, we would expect short-term volatility to ease and investors to return their attention to positive fundamental data that is emerging in the economy such as corporate earnings.  However, in the unlikely event that Congress fails to raise the debt ceiling and we default on our debt or if rating agencies follow through on their threat to downgrade U.S. Treasury obligations, we believe there could be far-reaching, disastrous economic and market repercussions that likely would extend well beyond the Treasury market.  Of course, the U.S. has never defaulted on its debt before and we are in unchartered waters, so the future is (as always) unknown.  We have faith that even if we were to experience default or a downgrade of U.S. debt, the markets will recover over time as they have done following other crises.

The wild card in all of this is the rating agencies.  Their threat to downgrade US debt regardless of whether the debt ceiling is raised or not has emerged as the biggest potential danger to the market.  Even though default on debt may be a low probability, there is at least some chance of a downgrade of the US Treasuries from AAA to AA should the leaders fail to make substantive progress on reducing the federal deficit.  Any downgrade of the Treasury debt likely would affect all the other sectors of the bond market.  A downgrade of Treasury debt could translate into similar downgrades of municipal debt and the debt of Fannie Mae and Freddie Mac.

Moreover, the proposed austerity measures could act as a drag on the economic growth which might have a negative impact on investment grade and high yield corporate debt.  We believe these asset classes might still outperform Treasury debt given their exposure to credit risk along with interest rate risk.  We have advocated diversifying the fixed income exposure by adding foreign sovereign debt.  We believe that active bond management in such circumstances is another way to hedge your portfolio as active managers have the ability to assess credit risk, duration risk among other risks to construct a portfolio hedging the risks.

If the debt deal does happen and the reaction in the Treasury market will likely follow the perception of the success of the agreement in bringing down the long-term path of the federal deficit. The yields will decline and the market volatility will stabilize. Most sectors of the bond market will rally along with the Treasury market in such a scenario.  Some sectors of the municipal bond market may decline based on the spending cut measures and the impact on the states.

Of course, nothing is certain and there are many other scenarios that could play out:

  • We fail to increase the debt ceiling; the Treasury avoids defaults by prioritizing payments.
  • We fail to increase the debt ceiling; the Treasury defaults on its debt.
  • We raise the debt ceiling and avoid default, but the deficit reduction package is modest and short term.
  • We raise the debt ceiling and avoid default, and we adopt a credible deficit reduction package.

Among the four scenarios described above, the last one probably would be the one greeted with the most enthusiasm both the bond and equity markets as well as the American people.

Investors are concerned and wondering what they can do to reduce the risks to their portfolios.  Nobody really knows the odds, but should the worst scenario play out, we believe the markets will plunge in the short term but eventually recover.  In five years, we expect this crisis likely would be a blip on the radar.

Of course, everything written above are only educated guesses.  Nobody knows what the future will hold. We will continue to monitor this situation carefully and seek out tactical opportunities to reduce risks for our investors.  Please contact us if you are nervous. We have some hedging strategies that might provide an alternative to soothe the current market volatility

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