Bond Experts Warn of Danger of Debt Ceiling ‘Turmoil’

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.

“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.