Talk of a downgrade on U.S. debt has investors worried about its potential impact on Treasurys, but some market watchers say other assets stand to lose even more.
As the possibility of the U.S. losing its Aaa debt rating draws closer, experts are starting to grow more concerned -- not about Treasurys, but about the ancillary effects such an unprecedented move would have on other types of bonds and even stocks. Since so many large institutions and countries own Treasurys, there are a lot of forces propping up government bonds. Other assets don't have the same buffer. For example, investors might dump riskier assets like stocks, while prices on municipal bonds and corporate bonds could fluctuate wildly. The dollar could also fall, bringing down the value of money market funds with it. "We could be a situation where there is a [Treasury] downgrade and yet you'd have a flight to quality to the very asset that was downgraded," says Joe Davis, head of the investment strategy group at Vanguard. "That would probably consist with equity markets falling and riskier assets underperforming."
Why are these other assets in the crossfire? A downgrade could lead to more stock market volatility as investors question their faith in the economic recovery, says Davis -- a trend which may have already started given Monday's 1% drop in the Dow Jones Industrial Average followed by Tuesday's nearly 2% gain. Investors may also dump other riskier assets like high-yield corporate bonds as they look for safer havens. Meanwhile, municipal markets may also be turned upside down if investors come to perceive some states as safer than the federal government, says Jeff Tjornehoj, a senior analyst at fund researcher Lipper. "There's definitely going to be ripple effects across the spectrum," says Tjornehoj. Even money market funds could be in trouble: A report released by Fitch Ratings this week found that the biggest challenge facing money funds if the U.S. defaults is the risk of worried investors redeeming their shares faster than fund providers can pay them.
As for Treasurys, the impact of any downgrade is expected to be minimal. While it could temporarily shake investor confidence in the market, investors domestically and abroad are unlikely to flee Treasurys, as the U.S. remains "one of, if not the, safest financial and economic system in the world," Rick Rieder, chief investment officer of fundamental fixed income for BlackRock, said in a written response. Some simply own too much in Treasurys to pull out now. For example, China currently owns $1.2 trillion of the U.S.'s more than $14 trillion in debt. Other large investors are planning to hold tight, too. For example, Davis at Vanguard, says the firm wouldn't change its asset allocation if the U.S. was downgraded because it has already factored in such scenarios into its planning. "The number of participants who automatically would have to sell U.S. Treasurys on a modest downgrade is not that dramatic," said Rieder."Most will hold the securities."
Of course, Treasurys could still take a hit. The U.S. was already downgraded to Aa from Aaa by Egan-Jones, a smaller rating agency whose downgrades of U.S. carmakers and other investments has preceded actions from the larger agencies in the past. A lower credit rating would limit the U.S. government's capacity to borrow, and this could lead prices to decline and yields to go up, says Tjornehoj. But then again, a downgrade could be avoided completely if lawmakers come to a timely deal over the debt ceiling. Moody's Investors Service, for instance, has said the Aaa rating would stay intact if the debt limit was raised and default was avoided.
For investors who are feeling jittery, investing pros warn against doing too much. Davis recommends rebalancing your portfolio to make sure your target allocations for stocks and bonds are in place after market's recent ups and downs. And Aaron Gurwitz, chief investment officer for Barclays Wealth, recommended in a commentary last week that investors reduce their exposure to dollar-denominated assets to a maximum of 85% because the debt issues could "push the dollar to new lows." Rieder said BlackRock is sticking with many of its high yield bonds, asset-backed securities, municipal bonds and other assets for now. "The potential for resolution, or the clouds parting at least somewhat, is definitely still possible."
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