This article originally appeared in the Financial Post.
By Nick Olivari
NEW YORK – The previously unthinkable, a U.S. debt repayment crisis, is now giving serious thinkers pause. Investors regard Treasury bills as being the safest place to put funds during in a crisis. But if U.S. debt itself is causing the crisis, where does the safe money go?
Financial advisers are starting to grapple with the issue of what might happen if the titanic Congressional debate becomes a full-blown debt repayment showdown.
“Politicians are fiddling while this thing is starting to burn around us,” said William Nobrega, managing partner of the Miami, Florida-based Conrad Group, an investment and strategic advisory services firm.
Demand has remained strong for the staggering $14.3 trillion in debt outstanding. Despite huge issuance in recent years, U.S. bonds have held up well and rates have stayed near historic lows, helped by Federal Reserve buying.
The debt issued by the United States is perceived as having the lowest default risk of any nation. And the Treasury market has already weathered its share of budget battles and shutdowns – five over the past three decades.
The difference now is that the economy is struggling to regain its footing from the crisis of 2008, with the added weight of monumental debt on its shoulders.
“We’ve never been in worse shape,” said Jacob Gold, president of Scottsdale, Arizona-based Jacob Gold & Associates, Inc., which provides high net-worth individuals and companies with investment strategies and wealth management solutions. “I don’t feel that there is a comparison of U.S. finances in the past.”
As a result, financial advisers and investors may have to prepare for a wide range of scenarios, from total government shutdown to a longer, drawn-out period of uncertainty. Here are some ideas.
The obvious investment play is to move away from U.S. government assets. But it’s not that simple.
The economies most accessible to global investors are also the most troubled. In Europe’s monetary union, Portugal, Ireland, Greece and Spain grapple with sovereign debt crises. Japan was already in the grips of economic stagnation when the March earthquake, tsunami and nuclear plant catastrophes pushed it back into its second recession in three years.
One alternative is to move into commodity-based economies that might hold up best. A financial crisis that pushes the dollar lower might well favor the South African rand, the Canadian dollar, the Australian dollar and or the Brazilian real, said The Conrad Group’s Nobrega.
An Australian government 10-year bond yields 5.23 percent, a Canadian 10-year bond 3.06 percent, the South African 10-year 8.215 percent and the Brazilian Real 10-year government bond 12.49 percent.
The caveat, of course, is that the United States is so deeply integrated with the global economy that a U.S. debt crisis would hit many nations. Even countries with vibrant and growing economies like China would be hit, as the largest U.S. debt holder and trading partner.
“There is clearly a possibility that the U.S., as with many sovereign issuers, may have a technical default,” said Tim Haywood, London-based investment director for fixed income at GAM where he co-manages $11.4 billion.
He said this would be “a monumental shock” to investors. Treasuries play “the role as the globally-accepted risk-free categorization.”
A technical default, a breach of some aspect or condition of the loan rather than a failure to make payment, would clearly indicate fiscal problems, and undermine that view.
The ramifications are so dire that most analysts expect U.S. and other global monetary officials will take every step to avoid it. Some big investing firms like Haywood’s have bought some insurance, using credit default swaps to protect against U.S. problems.
“We have bought credit protection on banks across the world, including some in the U.S., since the wider finance sector would be injured by this unlikely event,” said Haywood.
But such hedges are imperfect at best, and impractical for smaller investors.
Funds like Eaton Vance Global Macro Absolute Return take long and short positions in a wide range of countries to hedge risk. Direxion Monthly 10 Year Note Bear 2X Mutual Fund is one of a number of risk-leveraged funds that gain value as U.S. Treasury rates rise, but lose when rates fall.
NO WAY TO GAME IT?
Investors should not spend too much time worrying about dubious hedging strategies for a full-on U.S. debt default, said Guy Stern, head of Multi-Asset Management, who helps oversee Edinburgh-based Standard Life Investments Global Absolute Return Strategies (GARS) portfolio. SLI oversees $251 billion in total assets.
“We think the best way to construct portfolios is not to position for a specific event, or to hedge against a specific event,” Stern said. “What we try to do is look at the economic and market environment we expect and access returns from really diverse resources.”
He said investing in one scenario, such as buying bonds of fiscally disciplined Germany, while selling fiscally-stressed Japan’s bonds, would offer solid returns in any event, but in the event of a U.S. sovereign debt crisis, would provide exceptional returns.
With the risk of debt calamity in the air, some say that fund investors should look beyond yields at safety features. Tony Crexcenzi, Pimco’s executive vice president, market strategist and portfolio manager, said it’s prudent to find funds that offer a half-point lower overall yield, but offer to hedge against risk of ‘tail’ events, the so-called 100-year storms.
THE DOLLAR FALL, ALL OVER AGAIN
The wild card for investors is the weakening dollar, a byproduct of the U.S. fiscal impasse. The currency has lost 37 percent of its value since its last peak in mid-2001. While the Standard & Poor’s 500 index has fallen below its 2000 peak, commodities and emerging markets have enjoyed positive returns.
In the absence of widespread global uncertainty or volatility, Mauro F. Guillen, director of the Lauder Institute at the Wharton School in Philadelphia, expects the dollar to depreciate another 10 to 20 percent against the euro EUR over the next few years.
“If you are a Japanese, European or Chinese investor, you want returns in yen, euros or renminbi and you have to think very carefully about the value of the dollar,” Guillen said.
The 19-commodity Reuters-Jefferies CRB index is up 69 percent from when the dollar index peaked in 2001. The PowerShares DB Commodity Index Tracking DBC is an ETF made up of 14 futures contracts tracking the broad commodity sectors.
DOWN BUT NOT OUT
Amid all the rhetorical arguments on spending versus taxes coming out of Washington, D.C. as the U.S. butts against the debt ceiling, the overwhelming fact is that the U.S. has created as much national debt over the last seven years ($7 trillion) as it’s ever had historically. The good news is, if there is political will, there’s a way out of the doom-and-gloom scenario.
Despite the size of the U.S. debt, “I don’t feel like there will be a collapse in confidence in the U.S.,” said Jacob Gold.
Gold advised diversification and said it would be unwise to bet completely against the U.S., although the government will have to find solutions to the debt and deficit issues.
“There is absolutely a place, within a portfolio, for long-term U.S. Treasuries,” said Gold, advising some intermediate and long-term U.S. Treasuries for a portion of the portfolio.
His picks, even in a rising rate environment, include The Pimco Real Return Fund LP, Fidelity Inflation Protected Bond Fund LP, and the Fidelity Strategic Income Fund LP.
The deepest recession since the 1930s and two wars have blasted big holes in the government’s budget and pushed deficits in recent years to 10 percent of gross domestic product. A stronger economic recovery could certainly help.
“The least controversial way to reduce the deficit is to get the economy growing again,” says Lauder Institute’s Guillen.
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