The United States narrowly avoided defaulting on its debt — this time — with its last-minute deal to raise the debt limit.
That means Treasuries, the most widely held securities in the world, are still a safe haven. It had appeared touch-and-go for a short time, however. Amid the political wrangling in Washington DC, investors had avoided buying short-term Treasuries and yields spiked as the very real risk of default grew. With another debt ceiling battle likely early next year, the message for investors is clear: bond diversification isn’t just a good idea, it’s necessary.
BBC Capital spoke with four experts to find out what you need to know to keep your bond portfolio safe from future debt limit battles — and more. Edited excerpts follow with Mark Zandi, chief economist at Moody’s Analytics; Samuel Rines, an economist at Chilton Capital Management; Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott; and Matt King, chief investment officer at Bell Investment Advisors.
Q: If Congress hadn’t raised the debt ceiling, would financial Armageddon have followed?
Zandi: On October 17, the (US) government wouldn’t have actually defaulted on its debt. Thursday is the day the government was shut off from borrowing more money. Instead, the Treasury would be forced to draw on the cash that it already has on hand. By early November, government coffers would be running dry, though. True Treasury default would occur on November 15, when a big payment is due.
Besides that, investor confidence would rapidly erode. If investors didn’t get paid for their Treasury holdings, they would sue the government. Also, investors would demand higher interest rates on Treasuries to compensate for higher default risk, triggering inflation. Short-term investors, rather than ones holding long-term Treasury bonds, would be very worried about getting their money back as the government began defaulting on payments.
At some point, we would have a TARP moment. [In 2008 Congress tried to unfreeze the money markets by passing the Troubled Asset Relief Program (TARP). That money bought up mortgage-backed securities from financial institutions. It did not pass in Congress on the first vote and stocks fell nearly 9% that day.] Investors would head to the door. This scenario makes the probability of default unimaginable.
Q: Treasuries are also the glue that holds the financial system together, right?
Rines: Yes. Almost all debt is priced off of Treasuries. So there would be no risk-free assets for investors. Treasuries are also widely help by European banks, which have shifted into safer US and European bonds. So any default would have ripples worldwide, including to banks.
LeBas: Default threat has already affected the repurchase agreement market, which is essentially a secured loan that uses Treasuries as collateral. In theory, smaller banks could fail as defaults piled up. Also, many US bonds use Treasury yields as a benchmark. So, Treasuries have their tentacles in every corner of the financial market.
Q: How would money market funds, held by large numbers of investors, have been affected, since they hold a lot of Treasuries? In 2008, one money market wrote off bad debt and ended up breaking the buck, triggering investor panic.
Rines: some major financial firms like Fidelity have avoided buying short-term Treasuries. Financial firms have developed a capital preservation mentality, since they know what can happen during a financial crisis.
LeBas: Yes, many money markets have been preparing for the past week by hording cash and protecting themselves. They’ve been doing a good job getting ready for this Congressional showdown. Only minimal amounts of money have flowed out of money markets, which means that investors had not panicked.
Q: Congress has essentially just kicked the debt ceiling can down the road. How can investors protect themselves during future Congressional standoffs?
Zandi: there’s really nowhere to hide if the government defaults. Everything would get crushed. However, long-term Treasuries, which have much longer maturities [usually 10 to 30 years] than T-bills, may do better than anything else. However, if you’re holding emerging market bonds, they’ll go down like everything else.
Rines: International bonds funds are a good way to diversify. There is a lot of government paper in Germany and the UK to buy, and these governments don’t have this same dysfunction. Cash is also a good go-to place if it looks like there will be a default.
LeBas: Investors should always have about 10% of their portfolio in overseas bonds, especially sovereign ones, which are issued by governments, and high-quality corporate bond offerings.
King: Nervous investors learned some valuable lessons during the 2011 government debt-ceiling crisis. They wanted to go into cash. However, the investors who did were later left on the sidelines when the markets recovered. It was a painful lesson. So don’t let political risk deter you from your financial plans. Sit tight and wait it out. Investors should have a diversified fixed-income portfolio. Foreign bond exposure helps you hedge your currency risk. When parking money, look at high-yield savings accounts, which offer higher yields than money markets and no risk.
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