Investors mull options as debt ceiling negotiations continue

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Now that Standard & Poor's has issued a negative credit watch on U.S. government debt and acknowledged the possibility that no deal will be reached to raise the government’s debt ceiling, what should investors do?

That, of course, depends upon where they have their money invested. Someone holding a lot of U.S. Treasuries and Treasury-linked securities might find those holdings losing a lot of value if rates were to rise.

Similarly, if the U.S. government were to default, or even if it missed sending out certain legislatively mandated federal payments, such as the Social Security checks, it could have a dramatic impact on the stock market.

Jeffrey Saut, chief investment strategist at Raymond James, said the bond and equities markets are behaving as though investors remain confident that a deal will be struck before Aug. 2 and that there will be no default. 

“They certainly have not priced a default or a failure to raise the debt ceiling into bonds or equities,” Saut said. That, he warns, means that if one or both of those things were to happen, "interest rates on government bonds, and on municipal bonds linked to Treasuries, will rise and prices will drop and equities will take a big hit.”

Saut said investors who have taken no precautions at that point should “sit tight.”

"The worst danger is that people will panic, and sell their stocks when they drop," he said, adding that the crisis caused by such a default would likely be short-lived, meaning that markets would come back. "But people in that kind of situation have a tendency to panic,” as many did in the 2008 market crash.

A better alternative, he said, is to hedge your portfolio.

Saut said that by purchasing inverse leveraged ETFs, or, in the case of larger portfolios, buying a combination of long-term call options and short-term puts, investors can protect themselves against a drop in the market. This strategy would only cost investors a little in the event that a deal is struck and markets rise in response.

"I do this kind of thing all the time," he said. "I don’t know why everyone doesn’t do it. After all, you wouldn’t own a house and not buy insurance on it, would you? So why don’t people insure their portfolios?"

Meanwhile, Robert Tipp, chief investment strategist for Prudential Financial, said a default, or even a failure to raise the debt ceiling, is “extremely unlikely.” But he warns that it is also “extremely unlikely” that there will be any serious cuts in the U.S. budget deficit.

What that means, he argues, is that there will be no immediate problem and no immediate downgrade in the U.S. AAA sovereign debt rating, but that such a downgrade will happen over the next few years in a gradual way, “perhaps at one tick per year, going from AAA to AA2 to AA1 over time.”  Should that scenario occur, he said such downgrades might not have much impact on the interest rates on US debt.

“What we’ve seen in the case of other countries,” he said, “is that the actual rating is not what drives the rates of the bonds. It’s a country’s growth rate and general economic condition that drives the rates.”

The best strategy for investors, as hard as it might sound with all the threatening language coming out of Washington, Tipp said, is to “stay the course.”

Lindorff  writes for Financial Planning, a SourceMedia publication.

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