I can hardly wait for Wednesday morning, August 3rd. By that date at the latest we will know what Congress has decided to do about raising the United States debt limit. The “full faith and credit” of the United States and its AAA rating are at stake. We are all waiting to know what will Congress do and how. Will the US default on its debt? And what’s it mean for individual investors and their portfolios?
For investors, bonds represent the ultimate faith-based investment. The unique feature of bonds, unlike stocks and other investments, is the promise to repay. The value of a bond relies directly on the quality of that promise. The promise is expressed in the bond indenture language, pledging repayment based on the full faith and credit of the issuer. The US has always earned more faith than other issuers.
But this debt limit fiasco is making some investors question their faith.
No debt limit deal does not necessarily mean default for US Treasury bondholders. According to an analysis by Economist, the US Treasury has enough money to service its debt for some time without a debt ceiling increase. But the Treasury can’t make Social Security payments and pay the military its wages too, so something must give. When the President, the Secretary of the Treasury, and the Chairman of the Federal Reserve all say that failure to raise the debt ceiling would represent “Armageddon” for the United States, then it’s likely to be true. It would surely damage the Treasury’s AAA bond rating, which is based on rating agencies’ evaluation of the quality of the pledge to repay, and drive up the interest rate the US must pay to lenders.
On an optimistic note, the markets are not expecting default. The 10 year Treasury yield sits peacefully around 2.9%, even higher in price and lower in yield than when the crisis entered the popular press 90 days ago.
Faith turns out to be a decent basis for investment in many cases. Generations of investors have earned nice returns based on the repayment promises of nations, states, municipalities and corporations. But bonds do carry risks – AAA-rated issues typically very little, and corporate junk bonds far more. The debt limit debate offers a good opportunity to evaluate how much of your portfolio you want tied to the promise of borrowers.
How well is your portfolio is diversified beyond faith-based assets? It’s definitely worth doing the risk analysis today on how much of your portfolio is based on faith, and how much is based on other types of assets, such as:
If your portfolio is high on faith, make sure it’s done deliberately and with foresight and strategy. What Ronald Reagan often said regarding the Soviets also applies to an investment portfolio: “Trust, but verify.”
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