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This week will be dominated by events in Washington over the debt ceiling. It’s likely the negotiations will lead right down to the wire, and perhaps even beyond if the participants miscalculate. The structure of the negotiations virtually demand brinkmanship from both sides. Since concessions will be required by both parties, convincing their more partisan supporters that any agreement is a good one will require the optics of peering into the abyss of default in order to show that both sides held out until the last possible moment. In fact, the entire debate over the debt ceiling is a manufactured crisis, a needless, self-inflicted wound. Once the 2011 budget was approved, the necessity of an increase in the debt ceiling was assured. Separating the budget vote from the debt ceiling vote serves no useful purpose other than creating the present uncertainty. It seems obvious that the debt ceiling should be abolished as a needless distraction. This week will likely confirm the disdain with which many hold Washington.

And there is the possibility of a misstep, a negotiation miscalculation that leads to a technical default by the U.S. Indeed, even if a debt ceiling agreement is reached without that, a downgrade from AAA is looking increasingly likely over the next six to 12 months. Assessing how to respond to a U.S. Federal default or a downgrade is unchartered territory for investors. In many respects, it amounts to calculating how others will respond.

First let’s take a downgrade. Whereas rating agencies typically base their analysis on financial analysis of the debtor, in the case of the U.S., a downgrade would be largely a political verdict. As such, it’s not that insightful for any investor who’s independently following events. If S&P downgrades a corporate issuer, that’s relevant to investors because S&P has had access to the company’s financials, talked to management and carried out a normal credit analysis. But the rating agencies don’t know any more than I do about the U.S. and its ability/willingness to pay.

We can all form our own opinion. We all know the U.S. has a chronic debt problem. A rating agency’s altered view doesn’t reflect insight as much as a political assessment. I have my own assessment too. So the risk to a bond holder comes from the actions of other, rules-based investors. You would think just about every institutional investor in U.S. debt has had to contemplate a downgrade, and those confronting a potential need to sell if their own rules preclude holding U.S. debt rated below AAA are likely revising those rules so as to retain control over their own decision making. Some forced selling is likely, but it’s unlikely that a change in credit rating will trigger a large sell off. China’s holdings are so vast that it has little choice. It's a “hold to maturity” investor because it couldn’t sell what it has.

A default is more immediate and potentially more problematic. Depending on what payments are missed (i.e. Social Security payments, defense contractors, bond coupons, or all three), it could cause very real disruption. However, even here it’s not clear that treasury securities should be sold. First of all, any default will have to be short-lived because the government needs to keep on borrowing. A wholesale shutdown of federal payments to all and sundry would quickly be politically unacceptable. And in any case, where else does a U.S. bond holder go with his money? Banks could scarcely be better – they own huge amounts of government debt themselves. It’s rather like owning credit default swaps on U.S. debt. If they really are triggered, who can you rely upon to pay?

But it’s also quite possible that the economic disruption caused by a default, even a short term “technical” one, could push the U.S. economy back into recession. Bonds would quickly regain their appeal.

For our part, while we are not sanguine about the debt ceiling impasse, we see little reason to sell fixed-income assets. Although government bond yields have remained unreasonably low for too long, the alternatives to investment grade corporate debt are not obvious. But investors should also be prepared for weaker equity prices, driven in part by the very real possibility of a sharp growth slowdown made in Washington. We are not betting on that and remain close to fully invested. However, we retain some modest cash for the possibility that sharply lower prices may offer an opportunity.

In Deep Value Equities, our biggest holdings include Range Resources (NYSE:RRC), whose Marcellus Shale assets are looking even more attractive following BHP Billiton’s (NYSE:BHP) recent acquisition of Petrohawk (NYSE:HK). The natural gas E&P sector has generated strong returns of late. We also own Microsoft (NASDAQ:MSFT), whose businesses continue to perform well even while its stock continues to languish. One of our worst performing investments is Aegean Marine Petroleum (NYSE:ANW), a company which provides bunker fuel to ships. Its current stock price defies belief, trading at less than 6X next year’s earnings as margins should recover. The shipping industry’s fundamentals are currently terrible, with daily rates well below those required for profitability and an endless supply of new ships on the horizon. ANW provides the fuel to the recklessly increasing global shipping fleet, and while poor shipping economics are hurting it as well, it should ultimately be positioned to benefit from more customers.

In Fixed Income, we remain largely invested in two-year high-grade bonds through the iShares Barclays 1-3 Year Credit Bond (NYSEARCA:CSJ). While we like the long term prospects of an allocation to diversified emerging market debt so as to benefit from a declining USD, the uncertainties created by Greece and Washington have caused us to pull back for now.

We continue to build our MLP strategy (discussed in more detail here) and would use weaker prices to add exposure.

Disclosure: I am long RRC, MSFT, ANW, CSJ.

Source: Why a U.S. Default Need Not Be Bearish for Bonds