5 ETFs to Hedge the Debt-Ceiling Debacle

07/25/2011 8:30 am EST

Focus: ETFS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

While the fractious fighting in Washington continues, time is running out; investors may want to consider a hedge or two until the politician come to their senses says Ben Shepherd of InvestingDaily.

As the August 2 deadline to raise the US debt ceiling and stave off default rapidly approaches, Capitol Hill seems more concerned with ideological sparring than deal making.

We’ve already seen ripples in the Treasury market. The yields on long-dated bonds, which stand to lose the most in the event of a default, have already begun to rise.

The $14 trillion question is what would actually happen if the US were to default on its debt. Some politicians say the consequences would be negligible. Others believe a default could trigger another global credit crisis.

In truth, the outcome of a default is difficult to predict, because there are few historical precedents.

In the book This Time Is Different: Eight Centuries of Financial Folly, economists Carmen Reinhart and Kenneth Rogoff argue that the US has technically defaulted on its debt twice before:

  • The first event occurred in 1790, when the newly formed federal government restructured bonds issued by the states to fund the Revolutionary War.
  • The second example transpired in 1933, when Congress passed a bill that made it illegal for creditors to demand repayment in physical gold.

Both events were technically defaults. But they have little bearing on what may occur on August 3, because creditors were paid in both instances. In 1790, creditors simply received payment from the federal government rather than the state government; creditors in 1933 still received payment, though not in the form of gold.

Furthermore, the academic research indicates that investors didn’t lose money in either technical default. In 1790, investors actually made money. They bought inexpensive state debt that was expected to default, and were subsequently paid off in full by the federal government.

The situation in 1933 is more nuanced, because inflation eroded the value of dollars that were no longer backed by gold. Nevertheless, investors were still paid in full.

The 1995 budget impasse and government shutdown provides the best approximation of what could happen should the US default on its debt. At the time, President Bill Clinton and House Republicans, led by Newt Gingrich, went toe-to-toe on the budget, and an external default was narrowly averted.

Although US debt was put on negative watch by the major ratings agencies in 1995, these agencies never downgraded US credit. Today, US debt is on negative watch, and the ratings agencies have said they would downgrade the current AAA rating if the US government doesn’t strike a deal by August 2.

The impact of such a move would be felt across asset classes, not only in Treasury bonds.

According to a report issued by Moody’s, a US downgrade would trigger an automatic downgrade of about $130 billion in municipal bonds linked to the US. Furthermore, almost every other municipal bond would come under review. The ratings would be slashed on government bonds and mortgage-backed bonds secured by Fannie Mae or Freddie Mac.

Financials would be hit hard by a government default. The sector’s performance has badly lagged the S&P 500 since the debt-ceiling debate began in early March. And over the past few days, even generally positive earnings reports from the sector have failed to generate much excitement.

Investors and traders have long assumed that the government would bail out major US banks, should these lenders run into trouble. But that would be a challenge if the government goes broke—a line of reasoning that has dampened enthusiasm for financial names.

But the uncertainty stemming from a default poses the greatest risk to the US economy. If the default were to last only a few days, the results wouldn’t be catastrophic.

But if policymakers prolong the default with political gamesmanship, interest rate would certainly rise, curtailing business investment and consumer spending. This would be another blow to an already-weakened US economy.

Internationally, US dollars in the form of Treasury bonds account for a large percentage of global central-bank reserves. China alone holds about $1 trillion in Treasury debt, and the country’s policymakers are loath to see the value of their holdings decline because of US politics. A default would ratchet up tensions between the US and its creditors.

I do not believe the US will default on its debt. Recent press reports, citing highly-placed anonymous sources, suggest that lawmakers are developing a number of fallback plans to avert an immediate crisis.

Thankfully, politicians on both sides of the aisle appear unwilling to bring the US economy to the brink with a general election looming in 2012.

Consequently, investors shouldn’t make drastic changes to their portfolios. But those who believe a default is in the cards should minimize their US-dollar exposure.

A number of local-currency exchange traded funds, such as SPDR Barclays International Treasury Bond (BWX) and PowerShares International Corporate Bond (PICB), will help investors pare their exposure to the greenback.

Currency-specific ETFs such as WisdomTree Dreyfus Commodity Currency (CCX) will help one hedge against the dollar. As always, gold remains one of the best bets for investors, either in physical form or through an ETF such as SPDR Gold Trust (GLD) or iShares Gold Trust (IAU).

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