Fund managers can’t ignore debt ceiling politics

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    BOSTON (AP) ? How do you invest when the prospect of a financial disaster dominates small talk nearly as much as the midsummer heat wave gripping the nation?

    Mutual fund managers are trying to take a measured approach while talks to resolve the government’s debt ceiling dispute plod along.

    They’re bracing for the off-chance that political leaders fail to reach a deal by Aug. 2, possibly triggering a default that could send stock and bond markets off a cliff. Yet they’re also trying to avoid becoming overly defensive. There’s a risk of missing a market rally if political leaders take concrete long-term steps to get the nation’s finances in order.

    A market cataclysm may be what’s needed to get over the political impasse, says Franco Castagliuolo, a bond fund manager with Fidelity Investments.

    He says investors could be in for a “TARP-like moment” similar to the 777-point drop in the Dow Jones industrial average the day the House of Representatives rejected the initial bank bailout bill in September 2008. Responding to the market turmoil, Congress changed the bill and passed it four days later, helping to restore confidence.

    The possibility that stock and bond markets alike could be in for another jolt has Castagliuolo watching the ongoing developments in Washington as closely as he tracks Wall Street.

    “I spend a significant part of my day trying to read the tea leaves, and figure out where this is headed,” says Castagliuolo, co-manager of three Fidelity funds that invest in government-backed debt, including the $5 billion Government Income Fund (FGOVX).

    So far, markets haven’t reacted strongly, despite urgent warnings from President Obama about the consequences of a default or a downgrade of Uncle Sam’s debt by ratings agencies. Stock prices have been choppy but are largely unchanged from the start of the month, when the debate went into high gear. Yields for 10-year Treasury bonds have remained ultra-low at 3 percent. That suggests investors still see Uncle Sam as creditworthy.

    But expect trouble if no agreement is reached before Aug. 2, to raise the legal debt limit. That’s when the U.S. Treasury says it will exhaust its ability to borrow more and meet bill-paying obligations to everyone from soldiers to Social Security recipients.

    Here’s how a few market pros are managing their fund investors’ money in their respective markets:

    BONDS:

    Castagliuolo’s expertise is investing in Treasurys, as well as bonds issued by other federal agencies, and government-backed mortgage securities.

    Those investments will be directly affected by a default or a downgrade of the nation’s credit. Ratings agencies have warned they could soon remove the country’s top rating. A lower rating would mean it would cost the government more to borrow money. That’s because bond investors would demand higher yields to compensate for the elevated risk. Bond prices, which move the opposite direction of yields, would drop.

    The impact could spread to corporate bond markets, which take their cue from changes in Treasury rates. It could also lead to higher rates on everything from mortgages to credit card debt.

    Castagliuolo expects any failure to quickly reach a credible debt ceiling deal will widen the difference in yields between short- and long-term bonds.

    The short-term nature of Treasurys maturing within a month to a few years after they’re issued means their prices are less sensitive to an increase in interest rates. That’s because investors will receive their principal investment long before there are larger changes in the economy.

    Castagliuolo is prepared to buy more Treasurys if he sees the yield curve widen. He figures such a development would pressure politicians to get a deal done, even if it comes after Aug. 2. That could lead to a “relief rally” that would lift Treasury prices, and his funds’ returns.

    “Congress will ultimately get together and solve this thing in the near term,” he predicts.

    But he’s also concerned, because there’s no assurance markets would rise if a deal is reached. Bond prices could fall if the agreement doesn’t offer a credible route to long-term deficit reduction. If tough decisions are put off so a short-term default can be avoided, a ratings downgrade could result, spooking investors.

    “The stakes in the negotiations now have gone above and beyond the debt ceiling,” Castagliuolo says.

    STOCKS:

    If the government defaults, stock prices could tumble in tandem with bonds. That’s because Uncle Sam’s borrowing has become a crucial, yet weak, link in a global economy that’s emerging from a recession ? one due in part to governments borrowing so heavily.

    Adam Strauss, co-manager of the Appleseed Fund (APPLX), is holding plenty of gold and cash in his portfolio as a buffer. The stock fund recently had 17 percent in gold, including exchange-traded funds that hold the precious metal. Another 17 percent was in cash. Three of the top six stock holdings are health care stocks, which are typically less volatile than the market as a whole.

    Strauss believes a debt ceiling deal is likely before the deadline. His defensive approach reflects his belief that there’s an excess of debt throughout the economy, especially among consumers. The debt ceiling debate, he says, “is just a symptom of a larger problem.”

    Mike Buckius is also exercising plenty of caution at Gateway Fund (GATEX), which employs a unique tactic to reduce volatility. He buys “put options” on the stocks in the portfolio ? contracts giving the fund the right to sell shares at a specified price. That can limit losses in a declining market. Recently, the fund has had put protection on 100 percent of its stock holdings.

    “We’re certainly comfortable in this environment to be defensive,” says Buckius, a Gateway co-manager.

    He believes the debt ceiling issue has added to the fears of individual investors who have been slow to return to stocks since the last financial crisis.

    “A good outcome would encourage people to come back into the market,” he says. “But boy, if this turns out badly, it could really put investors on the sidelines.”

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    Questions? E-mail investorinsight(at)ap.org