Bond Experts Warn of Danger of Debt Ceiling ‘Turmoil’

BondDesk, LPL, BofA, DoubleLine, Franklin Templeton experts see dire consequences

The immovable object that is the debt ceiling debate in Washington actually budged a bit on Tuesday. But as the Aug. 2 deadline for action looms, Wall Street’s bond market experts are preparing for the worst if the U.S. government defaults on its Treasury debt.

chris shayne of BondDesk“Turmoil, disarray: those terms can be used interchangeably,” said Chris Shayne (left), senior market strategist for BondDesk Group. “I’ve been watching these debates in Washington, and I just hope that the grown-ups win.”

As President Barack Obama and Congress tussle over the terms of a budget—and hold the debt ceiling hostage in the process—capital market participants are growing increasingly worried that Washington will fail to raise the federal borrowing limit in time to prevent Moody’s and Standard & Poor’s from downgrading what is now their top, triple-A rating on U.S. debt.

The consequences of such a failure, they warn, would lead to catastrophes such as a sudden rise in interest rates across all bond classes, a drop in loans to businesses and consumers, a decline in the value of stocks and a crisis among institutional investors who are mandated to invest in triple-A rated bonds.

“The closer we get to the deadline with no resolution, the more negatively the markets are going to react. It would make the credit markets very hard to transact in,” Shayne said. “The worst-case scenario is that Washington can’t figure out a way to raise the debt ceiling, and you’ll see Treasury yields start to go way up, you’ll see Treasury prices start to fall, and it will probably have a ripple effect on all fixed-income markets because as Treasuries go, so goes everything else.”

Mandates Could Force Sudden Selloff of U.S. Treasury Debt

If the Aug. 2 debt ceiling deadline isn’t met, the United States would technically be in default, so the rating agencies would be obligated to downgrade the U.S. debt rating from its stellar triple-A status. And that, Shayne said, would wreak havoc on pension plans and other institutional investments that have mandates requiring them to hold only triple-A bonds.

“Downgrading debt from triple-A would create huge complications in the finance industry because of the mandate issue,” Shayne said. “There aren’t a lot of triple-A issuers in the world anymore. And all other debt is pegged off of the Treasury: corporate bonds, munis, short-term debt, mortgage-backed securities. It would throw the markets into a real state of disarray.”

High Yield Bonds May Be in for a Rough Ride

LPL Financial fixed-income strategist Anthony Valeri believes that the impact of a U.S. debt default would be worse on credit markets than on the Treasury market itself.

The U.S. Treasury will do whatever it takes to make debt service payments and conduct debt auctions—and that would include halting or delaying Social Security checks and Medicare payments, Valeri said. At that point, Treasuries may decline, “but they’re still the best house on a bad block” compared with Europe. The greater risk is to corporate bonds, especially high yield, he said.

“The more economically sensitive bond sectors, like high yield bonds, will be negatively impacted by a Treasury default,” Valeri said. “Since the Treasury is still the backbone of the bond market, and all other bonds are priced in relation to Treasuries, you could adversely affect liquidity in other bond sectors. What would happen then is that investors would demand a bigger risk premium on those corporate sectors and cause yield spreads to widen and those sectors to underperform relative to Treasuries.”

U.S. Investors Already Have Trouble Abroad

The terrible state of other economies around the globe adds to U.S. markets’ potential troubles, warned Anil Lalchand, credit research director for DoubleLine Capital.

In a white paper written for DoubleLine, Lalchand said that U.S. credit portfolio managers need to monitor the exposure of U.S. banks to countries including Greece, Portugal, Ireland, Italy and Spain. Why? Because these managers are counterparties to banks and broker-dealers, he said.

“The interconnectedness of the U.S. and European banking systems can hardly be lost on markets and policymakers post-bailout of American International Group,” Lalchand wrote.

As of first-quarter 2011, Bank of America’s exposure to Greece stood at $677 million, while its total exposure to the other countries came to$16.9 billion, or 0.75% of BofA’s assets, Lalchand’s research shows.

It also shows that JPMorgan’s exposure to the five countries was about $20 billion, or 0.91% of total assets, as of Q1; Citigroup’s total sovereign exposure was approximately $265 billion; Goldman Sachs’ exposure to Ireland was 0.90%, at $8.3 billion; and Morgan Stanley’s Q4 2010 exposure exceeded 1% of the company’s assets, with exposure to Italy at $4.6 billion, or 0.57% of assets.

The Upside: Global Fixed-Income Opportunities

Some fund managers are already pricing in rising interest rates and adjusting their portfolios accordingly.

For example, Michael Hasenstab, lead manager of the Templeton Global Balanced Fund’s fixed-income assets, believes that interest rates will rise this year both in fast-growing emerging markets and in the developed world where rates remain at historically low levels.

“Even in the U.S., where we expect the recovery to be moderate, we believe improving economic activity will combine with the historically large financing needs of the public sector to push up yields,” Hasenstab said.

As a result, Hasenstab has positioned the fund’s fixed income portion to help protect against rising yields and to capitalize on them. “This involves both limiting duration exposure in most economies—we own no U.S. Treasuries or Japanese government bonds—and using currency and other exposures to potentially benefit from rising rates,” he said.

But Downside Risks Dominate

In a comment for Bank of America Merrill Lynch, North American Economist Ethan Harris noted that as the debt ceiling’s Aug. 2 deadline looms closer, the probability is high for a serious shock to the markets and economy.

“Some analysts argue that violating the debt ceiling would be a good thing because it would prompt a sensible deficit reduction plan. We are doubtful,” Harris wrote in his July 15 macro viewpoint. “Violating the debt ceiling would scare the capital markets, force at least a temporary credit downgrade to default, and it would potentially permanently damage the safe haven and reserve currency status of the dollar.”

To address the nation’s economic ills, the government needs to come up with at least a $3 trillion austerity package over 10 years to put the debt-to-GDP ratio on a slowly declining path, Harris asserted.

“Our sense is that the credit rating companies are likely to downgrade U.S. debt to AA if the agreement does not imply an improving debt path,” he wrote. “A sensible budget process has already been abandoned as politicians blast away at each other in public. The risk is that things get much worse. We wonder: Does Washington need a capital markets crisis to prompt action? This is what we have seen in Europe over the last year and this was the case with other unpopular legislation like the TARP bank bailout back in 2008.”

The U.S. economy is fragile, Harris added, but an increasingly popular view is that large and immediate spending cuts might help growth by showing that the U.S. is serious about deficit reduction.

But a quick glance at the literature confirms that this is wishful thinking, he said: “Open up almost any undergraduate macro textbook and go to the section on ‘fiscal multipliers:’ spending cuts have a bigger negative impact on growth in the first year than tax increases. Greece provides a powerful recent reminder of the risk of rapid fiscal consolidation.”

Read PIMCO’s Gross Warns, Don’t Mess With Debt Ceiling—Raise It at AdvisorOne.com.

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