How to Play the U.S. Debt Downgrade: Fixed Income

Includes: AGG, BND
by: Clayton Reeves

We all know the negatives associated with a debt downgrade for the United States. Borrowing costs will increase by as much as $100 billion according to JP Morgan Chase. Also, it represents a hit to fragile consumer confidence and could send the markets into even more of a tailspin. However, is there a silver lining to this storm cloud? Could it be that our political system and citizens needed a strong kick in the rear to spur action?

I wrote last week the reasons that I thought the economy was on the verge of a downturn. In response, the market plummeted, losing as much as 500 pts in a day and erasing all 2011 gains. Then, S&P downgraded U.S. debt at the end of the week; this move threatens to send the markets into a downward spiral. David Rosenberg, whose daily thoughts are among the most insightful in the markets, wrote prophetically on July 29th about the potential for the rating agencies to downgrade U.S. debt despite any sort of debt deal. He said then that:

Perhaps a debt downgrade by the rating agencies would be a wake-up call. It was certainly in Canada back in 1994 and who would have thought that the country would be the poster boy for fiscal stability 17 years down the road? We actually went back over the last two decades and found nine instances when a sovereign of a developed nation was downgraded from Aaa by Moody’s:

  • Australia in September 1987
  • Norway in July 1987
  • Finland in October 1990
  • Sweden in January 1991
  • Italy in July 1991
  • Canada in June 1994
  • Iceland in May 2008
  • Japan in May 2009
  • Ireland in July 2009

You will see some familiar names on that list, with stagnation central, Japan and PIIGS VIP Ireland as the two most recent additions. Go ahead and add the United States to that list. So what is in store for the U.S. over the next few years? David continues by asking that very question:

What happened next? In the following year, the primary budget, on a median basis, declined by 2 ½ percentage points. Real GDP growth, on a four quarter trailing basis, slowed from 1.4% to -0.4%-- a recession was the norm. And while equity market performance was quite spotty, the one common thread was that the 10 year bond yields fell in each case over the next three months, and outside of Italy, [were] down dramatically in the next 12 months as the fiscal squeeze triggered a huge compression of economic activity. The median decline was 50 bps in the first three months and 70 bps in a year.

So, it looks like this specter of debt downgrade will continue to haunt the United States at least for a couple years. A downturn is inevitable and the U.S. should lag global growth in the coming months. The opinion by some that our economy will avoid another economic downturn is even more misguided now that this downgrade has been made. David agrees that a recession is almost guaranteed:

It is evident that we will be going into another recession with the levels of output, employment and income all lower now than they were prior to the last contraction phase. I have already pegged a U.S. recession as a virtual certainty.

David continued in another statement to explain that although the debt will not be triple A, it is still the debt of the United States and the downgrade could be more symbolic than anything else:

Will anyone really fear a default in dollar-denominated debt by the one country that has the power to print those dollars if need be? True, Treasuries won’t be triple A, so in the rater’s eyes, they won’t be as safe as, say, mortgage-backed CDOs were prior to 2007. But they will still be safer than Japanese government bonds, which manage to clear the market at only 1.1% in the 10-year space.

A little jab to the ratings agencies there! Of course U.S. debt isn’t as sparkly and shiny as CDOs in 2007, but then again, when did the ratings get their legitimacy back? Why make the downgrade now? I’m finding it hard to believe that anything fundamental changed as a result of the debt ceiling being raised. All of the political barriers that S&P speaks to in their decision were present before the debt ceiling was raised, and are pervasive in the U.S. democratic system. To say that their decision was based on a single congressional vote that fell short of expectations is short sighted.

But, regardless of my opinion of S&P’s decision or yours, the downgrade has been made and the markets will do what they do best: react. David expands on what to do in both an economic downturn and an economy that has recently been downgraded. Rosenberg has some insight into the pattern markets take after a downgrade:

The pattern is unmistakable – bond[s], contrary to popular opinion rally after the downgrade – their roughest days are before the event. This is not simply “buying the fact,” it is about the degree of fiscal retrenchment and the bite it takes out of economic growth that precipitates the rally in the fixed income market.

So, as the downgrade starts to impact the markets, Rosenberg’s play is fixed income. He also says that strategies to preserve capital and minimize cyclical exposures will produce alpha:

The key is to be positioned appropriately for the part of the business cycle we are on the cusp of entering. In a nutshell, what that means is carefully constructed investment strategies and portfolios that preserve capital, minimize cyclical exposures, enhance yield and thereby provide for significant risk-adjusted returns - even in a recession.

The downgrade is a monumental event in the history of the United States. Monday morning is sure to leave plenty with hurting portfolios and wounded confidence. However, it isn’t the death knell for the United States and it doesn’t mean the end of the world. I expect to see plenty of financial Armageddon articles popping up in the near future, but they will miss the point. This new turn of events will stymie the recovery, let U.S. enjoy some more stagnant growth and prop up the unemployment rate. Can’t hardly wait.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.