US shutdown: Default seems unthinkable but investors have options

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Investors who behave conventionally are likely to get burned if the political standoff over the federal budget. Reuters Investors who behave conventionally are likely to get burned if the political standoff over the federal budget. Reuters
SummaryUS stocks retreated for a second straight day as the shutdown dragged on and the dollar weakened.

more question marks about gridlock and growth. That's painful to sit through, but it's fertile ground" for increasing returns.

For longer-term mom-and-pop investors whose exposure to markets is concentrated in their 401ks, increasing cash holdings could offer some protection, particularly for older savers heavily invested in typical stock and bond funds.

SITTING ON CASH

Dan Yu, managing director of EisnerAmper Wealth Advisors LLC, said his clients' portfolios are sitting on cash of between 10 to 12 percent, up from 2 to 3 percent in July. "We're cash-heavy but I might be a buyer if we see a 5 percent pullback in the stock market," Yu said.

After the 2011 debt ceiling fight ended with Standard & Poor's stripping the United States of its AAA credit rating, the benchmark S&P 500 index had one of the most volatile years in the market's history, logging the first zero percent performance in decades.

But as the credit crunch in 2008 taught investors, even cash isn't safe when panic and forced selling ensue.

That's because many money market funds invest in short-term cash equivalents such as T-bills, which in this case could be most at risk if the U.S. government goes into technical default.

Reserve Money Market Fund shares fell below $1 in 2008 when it was forced to write off debt issued by Lehman Brothers, whose failure marked the depth of the global financial crisis.

Investors have been avoiding Treasury bills that come due in mid-to-late October and early November, which have the highest risk of a default.

That has pushed one-month Treasury bill yields above those offered on longer-dated Treasuries. One-month yields rose to 0.13 percent on Thursday, the highest since November, and well above the 0.02 percent three-month yield.

Most investors expect longer-dated U.S. Treasuries to hold up fairly well in the leadup to the debt ceiling showdown, and perhaps to rally even in the event of a default. That's what happened in 2011 when the U.S. credit rating was downgraded.

That is partly because few markets offer the size and liquidity of the U.S. government bond market. And it is partly because few expect a default to last long.

"Missing a single payment or a series of social security payments is incredibly damaging, of course, but that's still very different from Argentina informing the world, as it did a few years ago, that it's defaulting on its debt," said Andrew Milligan, head of global strategy at Standard Life Investments.

"What it does, though,

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