Investors map course for U.S. debt downgrade

Loosening investment policy guidelines and moving to diversify fixed-income portfolios dominated by U.S. Treasuries top institutional investors' to-do lists amid the threat of a ratings downgrade of U.S. government debt following Washington's contentious Aug. 2 debt ceiling deal.

(As Pensions & Investments went to press late on Aug. 5, Standard & Poor's announced it was downgrading the U.S. government's AAA credit rating to AA+. The downgrade, the first ever for the U.S., was made because of concerns that spending cuts agreed on by Congress to raise the nation's borrowing limit don't go far enough.)

Pension fund executives, money managers and investment consultants say a critical mass of political and economic uncertainties now is spawning a wave of discussions to game out responses to possible scenarios.

The spike in such discussions over the past week or so reflects the view that the outcome of Washington's latest high-stakes game of chicken — with President Barack Obama acceding to opposition demands to cut trillions of dollars from the country's debt over the coming decade as the price of avoiding the first default in the country's history — won't prove sufficient to convince major ratings agencies to maintain that top rating for U.S. paper.

Despite the $2 trillion deal, major ratings agencies made it understood they were expecting $4 trillion in cuts, leaving it “likely that the U.S. will be downgraded,” noted Erik Knutzen, chief investment officer with Cambridge, Mass.-based investment consultant NEPC LLC.

The day of the deal, Moody's Investors Services confirmed its AAA rating for U.S. government bonds, but for the first time cut its ratings outlook to “negative” from “stable” — noting the risk of a downgrade should, among other things, the country's economic outlook deteriorate or further budget cuts not be adopted in 2013.

Managers, in talks with clients, have begun preparing for “a number of potential outcomes,” said Stephen Johnson, a managing director and U.S. CIO with DB Advisors, the institutional arm of Deutsche Asset Management, New York. Those talks have touched on tweaking investment policy guidelines that call for fixed-income portfolios to maintain a target average credit rating, as well as broader asset allocation responses, he said.

Without a relaxation of those investment policy guidelines, a downgrade of U.S. debt to AA from AAA could force investors to either upgrade the quality of their BBB bucket or find other AAA assets, including securitized instruments such as asset-backed securities, none of which offer even a fraction of the depth of the U.S. Treasury market, noted Michael Mata, a senior vice president and head of multisector fixed income with ING Investment Management in Atlanta.

The danger that a sudden downgrade of U.S. government debt could force investors to dump “temporarily depressed securities” prompted investment consultant Mercer LLC on July 29 to urge clients to put an automatic tripwire in place to suspend or adjust minimum quality standards for their fixed-income portfolios “if and when” a downgrade occurs, said Terry Dennison, Los Angeles-based director of consulting for Mercer's U.S. investment consulting business.

Even after a downgrade, U.S. debt will still theoretically be riskless and the dollar will remain the reserve currency. Still, it will be “completely unexplored territory,” making it difficult if not impossible to immunize investors' portfolios, Mr. Dennison said. Against that backdrop, an automatic mechanism to relax investment guidelines in the event of a downgrade will provide “the luxury of time” needed to respond thoughtfully, he said.

While the fallout could ultimately prove less than earthshaking, it remains crucial for money managers and clients to achieve a meeting of minds ahead of time, observers say.

A downgrade would be “a major headline event, but from an investment standpoint, I don't think it will affect the bond market in a major way,” with U.S. Treasuries remaining a uniquely liquid and safe investment, said Chris Orndorff, a senior portfolio manager with Western Asset Management, Pasadena. He said his firm has been very proactive in getting guidance from clients as to how to respond to a downgrade, with the responses received convincing him there'll be no panic in the event.

Celia Dallas, a managing director and co-director of research with Boston-based investment consultant Cambridge Associates LLC, said even if a ratings drop to AA suggests U.S. Treasuries aren't entirely risk-free, that will remain a “relative concept,” with U.S. paper remaining a defensive, preferred investment for the foreseeable future.

Ms. Dallas said recent developments have reinforced Cambridge's recommendations to clients to diversify their currency exposure, for example, with bigger strategic allocations to emerging markets debt and currencies to reflect “changes in the global balance of power.”

The same logic will prompt investors to allocate more to those relatively fast-growing emerging markets across other asset classes as well, including public and private equity, infrastructure and real estate, noted Catherine M. Keating, CEO of U.S. institutional asset management with J.P. Morgan Asset Management.

In the realm of sovereign bonds, ING's Mr. Mata also anticipates more diversification. A U.S. default was “always a red herring,” but investors have to be concerned about purchasing power, in terms of what the dollar is going to be worth going forward, he said.

One industry strategist, who declined to be named, predicted the latest spectacle of dysfunctional Washington politics could have serious ripple effects, including an accelerated move by central banks to diversify their reserves away from dollar-based securities.

More broadly, observers say with the U.S. government stepping back from the stimulus game, it has become harder to outline a scenario where the U.S. economy anytime soon can return to trend growth, let alone the above-trend growth that could lower unemployment.

While many market veterans have come to expect a third round of quantitative easing from the U.S. Federal Reserve, few place much hope on the remaining plausible candidates to lead an economic recovery: an export boom or a spate of capital investments by cash-rich U.S. companies.

The weakness of European economies and slowing growth in China will undercut hopes for a surge in U.S. exports, some economists warn. That same weakness at home and abroad, meanwhile, will only add to the incentives U.S. companies have to target faster-growing markets overseas for their capital investments, noted Cambridge Associates' Ms. Dallas.

With the fiscal props to the global economy “being pulled away,” the conviction is deepening that investors will be looking at low growth for a long time to come, said Jack Malvey, New York-based chief global markets strategist with BNY Mellon Asset Management. Exacerbating that outlook is a diminution in confidence that U.S. policymakers are up to the task of dealing with the complex policy issues facing the developed world today, he said.

DeAM's Mr. Johnson agreed. The policymaking process surrounding the debt ceiling had a “reality show” aspect that surprised people, potentially undermining the confidence of investors, he said. The fear that “we're going to watch this again in the coming years” could prove a further drag on both markets and the economy, he added. n