Giving Thanks to the US Debt Ceiling
October 14, 2013
“The risk is in the bond market, and the US government is giving us the opportunity to re-position…”
The world is on the edge of a knife as all eyes are on the US Senate as they are the ones now charged with finding a solution to the political wrangling that, if left unsolved will lead the US to a default on their debt.
Almost everyone believes that the US will come up with a solution, or at the very least a short-term solution to avert a default– equities have held firm through the shutdown, rallying last week – and only down modestly today after a weekend of negative progress.
I’m currently on a train between Florence and Venice, on the final leg of my honeymoon. One thing Italian hotels give you plenty of access to, is English language business television. CNBC, Bloomberg and CNN are essentially the only English channels in the hotels we’ve stayed in. The coverage has been overwhelmingly debt ceiling focused, with every report from ‘unnamed staffers’ in the Capitol getting significant reporting and analysis.
While I’ve got an hour or two (going 300 km/h) to reflect on everything I’ve heard in the last week, maybe the most interesting is that, if the US were to default, there is a belief that treasury yields would actually go lower. Secondly, Obama’s comment to reporters that ‘what matters is; what do people buying US treasuries think?” should focus our view on treasury markets and not stocks.
Treasuries are reflecting a concern that the equity markets have seemingly moved passed.
If no solution leads to lower yields, it follows that a solution to the debt crisis could lead us to higher treasury yields. China and Japan, both large owners/buyers of treasuries, have both been in the media this week, pressing the US Government for a solution, much like a large shareholder would urge company management to sell a division or declare a dividend. I do believe that all foreign governments will have to rethink their treasury holdings once this ‘crisis’ is over.
From the chart below, we see that the US 10 year, has move from under 2% to almost 3% over the May/June period, a time when many investors got re-introduced to the concept that bonds, can lose money.
10 Year Yield – Bloomberg.com
Currently, 10-year treasury yields are sitting at 2.60-2.65%, some 35 basis points lower than they were before the government shutdown and concerns over the debt ceiling. Now 35 basis points doesn’t feel like a lot, however, when multiplied through the modified duration of 8.5 years on the 10 year, a move back to ~3% equates to an approximate 3% decline in the US 10 year bond.
The US 10 year is a good proxy, as many large bond funds, have average durations of 7-9 years. So, if you follow the logic… that logic will prevail and the US Government will not default on its obligations, then you might also believe that a return to the 3% level (or higher with less foreign buying) on the US treasury could occur.
In this environment, you must consider re-positioning your bond funds and longer term bonds and also perpetual preferred shares, and in the absence of inflation REITs, infrastructure and other bond like equities.
Perhaps, this debt ceiling debate, is giving us an opportunity to reposition our fixed income portfolios, after many investors were paralyzed when rates increased in May and June.