The Credit Downgrade: More Answers To Questions

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OCEAN CITY — In the second of a two-part series, Lisa Shalett, Chief Investment Officer of Merrill Lynch Global Wealth Management, explains Standard & Poor’s decision to downgrade U.S. government debt, puts recent market volatility into perspective, and suggests steps investors should consider taking now to safeguard their investments.

(BOLD QUESTIONS)But won’t the downgrade cause interest rates to shoot up? And how is that likely to affect investments in Treasury bonds? 
We don’t believe that the downgrade will lead to any immediate up-tick in interest rates. For a variety of reasons not likely to change any time soon, U.S. Treasury bonds are still regarded as the world’s main "low risk" asset. In fact, the recent concern about Europe, global growth, and the debt ceiling debate has resulted in more investors moving into Treasuries. 10-year Treasury yields recently sank to historic lows, and the trend shows little sign of abating. Over the longer term, some analysts predict that S& P’s decision could cause a modest increase in rates — of as much as ½ point for 10-year Treasuries, and a full point for 30-year bonds. We tend to agree, but I would emphasize that the changes are likely to be gradual. Nonetheless, at current levels, we’d also agree that 10-, 20- and 30-year Treasuries are probably over-priced, and have begun encouraging clients to consider re-allocating some of their holdings to bond funds with very short-duration bonds.

What could the downgrade mean for big holders of Treasury bonds, such as money market funds?
The immediate and direct impact of the downgrade on money market funds should be minimal. While money market funds do hold roughly $1.3 trillion in direct and indirect exposures to Treasuries, the vast majority of these holdings are in maturities of very short duration — and the S&P decision’s doesn’t affect the U.S.’s rating for short-term credit. It also appears that most money market funds have been preparing for this scenario for weeks, building up their cash flow in case there’s a temporary pick-up in the number of investors asking for redemptions.

What does the downgrade mean for municipal bonds?
The impact on the vast majority of munis should be modest, although some areas that rely strongly on government guarantees to fund their needs could be affected. More likely to influence the muni market will be the ongoing efforts by the federal government to reduce spending, particularly if entitlements and infrastructure spending are cut seriously. We continue to recommend municipals to tax-sensitive clients who are seeking yield, but we have also been encouraging clients to focus more on actively managed municipal bond funds, where professional managers can keep a closer eye on credit quality and revenue backing.

Have the events of the past week changed your point of view on whether our economy could slip back into recession?
We believe that the probability of a "double-dip" recession occurring in the U.S. next year has definitely increased — to the point we now see a 35% chance of that happening. The market has already started to prepare for the possibility of a recession in developed economies, as a result of both weak economic readings and the fear of political gridlock on both sides of the Atlantic. While these developments are cause for concern, it’s important to bear in mind that U.S. corporations are in excellent financial health. Meanwhile, the July jobs report offered a positive data point, suggesting that private payrolls are still expanding, and at a level above what you would expect if the country were in a recession.

What kind of portfolio advice are you giving clients in this environment?
Our previous advice basically still holds true. The recent market declines have created select opportunities for patient investors; panic selling has never been a successful strategy. We believe that the recent volatility, though distressing, will increasingly be a feature of capital markets as the world continues to heal from the financial crisis. Against this backdrop, we continue to advise clients to move toward more global, flexible and dynamic investment strategies. The old "buy and hold" strategy is not likely to work in this environment. Investors should manage risk actively, rather than depend solely upon being diversified. Investors may want to look at some alternative (or "alternative-like") investments, such as non-traditional mutual funds. Market-linked investments, especially those offering market downside protection, are also worth considering.

We believe that risk-based assets, like most equities, will stay under pressure over the medium term as investors await potential positive catalysts from policy makers. That said, we would caution against the urge to either sell in a panic or "buy the dips." It’s worth noting that in every case in the past where a country’s debt has been downgraded, its stock market was up one year later.

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)

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