The ongoing debt-ceiling standoff between Democrats and Republicans could result in buying opportunities for institutional investors as long as widespread faith that the two sides will eventually do whatever is necessary to avoid a U.S. debt default proves well-founded.

If not, all bets are off.

For now, even as the “X-date” where the government won’t be able to cover all of its Treasury bonds and bills coming due approaches— as early as June by some estimates — most market participants say they’re confident key players in the unfolding political drama remain rational actors, intent on avoiding the economic debacle a default would unleash.

In that telling, the critical mass of uncertainty that would ensue — including a full-blown banking crisis, millions of layoffs and the need for higher interest rates going forward to support demand for Treasury bonds that suddenly look less than risk-free — remains the best guarantee that a default won’t occur.

“The mutually assured destruction of debt default is exactly what keeps it from happening,” said Charles Van Vleet, assistant treasurer and CIO of Providence, R.I.-based Textron Inc.

Funding for national parks, construction projects and research may be suspended but “I do not think we would ever default on debt,” said Mr. Van Vleet, who oversees $13 billion in Textron defined benefit and defined contribution retirement assets.

“It would be apocalyptic to not reach an agreement in some reasonable amount of time, and who wants to be the one that carries the blame for that,” agreed Jim Jackson, co-CIO of San Antonio-based Victory Capital Management Inc.’s fixed-income business.

For some observers, that reasonable amount of time could include a few hours of default but not much more.

While Washington’s ever-more visceral political discord provides reasons to think this latest in a long series of debt-ceiling standoffs could end up being “relatively contentious and drawn out,” a government default on its debts for a period of weeks or months remains “almost unimaginable,” said Jay Love, Atlanta-based U.S. chief investment strategist with Mercer Investments LLC.

Some observers aren’t willing to go that far.

Deborah B. Goldberg, Massachusetts state treasurer, at a May 2 investment committee meeting of the $89.4 billion Massachusetts Pension Investment Management Board, expressed concern that “nobody really believes that Congress will allow the country to go into default,” effectively downplaying a “thoroughly unpredictable” political backdrop now.

“I think today there is a distinct possibility of a default — unimaginable as it is,” agreed Cynthia Steer, investment committee chair of Washington-based MissionSquare Retirement, which reports $68 billion in assets under advisement for public sector employees, including $34 billion in assets under management.

“The polarization of the U.S. has reached a point where it is at least a 5% to 10% possibility, rather than zero,” Ms. Steer said. “There are no adults in the room,” she added.

Mercer’s Mr. Love, by contrast, pegged the possibility of default at a mere 0.1%, and declined to raise the odds to two-tenths to reflect Washington’s descent into incivility. “I do think there’s still some rationality and sanity even if it’s hidden behind bare knuckle” political strife, he said.

Most analysts, meanwhile, contend that there’s very little institutional investors can do to protect their portfolios from such a low-probability, high-risk scenario.

“We do not expect institutional investors to make large, pre-emptive repositioning in advance of the X-date,” said Simon England-Brammer, London-based senior managing director and head of EMEA and Asia-Pacific global client group with Nuveen.

“At the margin, we expect investors to position more defensively and to hedge against heightened volatility, but not to make material changes to overall asset allocations,” he said.

Elizabeth Burton, chief investment strategist, client solutions group with New York-based Goldman Sachs Asset Management, said for the big public pension clients she focuses on the debt ceiling isn’t top of mind, either because they know there’s not much they can do to prepare for it or they’ve got bigger concerns now, such as how to manage liquidity.

A default is “a very, very small probability risk to take a lot of potential reward off the table for,” agreed Mr. Love. “The calculus for doing so doesn’t work,” he added.

And while the latest round of turmoil may leave market participants hoping the dominant roles played by the U.S. dollar and Treasuries in their portfolios give way to greater “multi-polarity” down the road, that remains a far off prospect — even if an argument can be made that this debt-ceiling “kabuki” will serve as an “accelerant” for that future, noted Amar Reganti, managing director, broad markets investment products and strategies with Boston-based Wellington Management Co.

As a former deputy director of the Treasury Department’s office of debt management, Mr. Reganti was involved in managing the debt ceilings of 2011 and 2013.

“There’s no alternative safe asset,” noted Andrew Palmer, CIO of the $64.6 billion Maryland State Retirement & Pension System, Baltimore. “I guess we could buy some gold, but we couldn’t buy enough to provide … real protection. We pretty much have to trust the authorities to make good decisions,” he said.

Political theater

Adherents to the belief that everything will work out in time take solace in the fact that debt-ceiling standoffs have practically become a staple of the American political scene and even the most contentious of past episodes — in 2011, when it took a market plunge sparked by an S&P downgrade of U.S. debt to AA+ from AAA to forge a compromise — have ended without a default.

The current standoff, then, should be seen as “more of the same” rather than something new, said Victory’s Mr. Jackson. “There’s always a lot of hype around it … by intent,” with both sides seeking to push their policy proposals through “by using the debt ceiling as a hammer,” he said. “They’re incentivized to really heighten the level of fear as far as not agreeing on something,” Mr. Jackson added.

Meanwhile, market sell-offs have a crucial role to play in that political dance, money managers say.

So far, signs of stress have been limited to corners of the financial markets most people don’t pay attention to — such as the recent four-week Treasury bill auction and credit default swaps for U.S. Treasuries — rather than markets followed closely by the public, such as U.S. stocks, noted Wellington’s Mr. Reganti.

Investors have yet to see the kind of broad reaction across all markets that has served as a “forcing mechanism” pushing policymakers toward compromise in previous standoffs such as 2011, he said.

The T-bill market is “certainly pricing in some level of risk,” said Victory’s Mr. Jackson, with the T-bill that matures May 30 yielding about 4.3% while the one maturing the next day yields about 5.3%.

As the day of reckoning draws near for covering outstanding Treasury debt coming due, signs of capital market stress are likely to become broader and deeper, market participants say.

“We expect markets to react as we get closer to the ‘X-date,'” including a sell-off of risk assets and a widening of spreads, said Nuveen’s Mr. England-Brammer.

The closer the Treasury comes to defaulting, “the higher the stakes go” and the greater the chances of the kind of broad market sell-offs that will bring opposing political players to the table, Mr. Reganti said.

Even if most market participants continue to believe the current debt standoff will follow the pattern of prior episodes, they concede there are reasons to be a bit more on edge this time around.

High on the list of concerns is the vulnerability of Republican House Speaker Kevin McCarthy, reflecting a razor-thin majority for his party in the House of Representatives that leaves him with relatively little room to maneuver in extracting concessions from his members.

“I’m a little more concerned this time,” conceded Mercer’s Mr. Love. While an agreement that avoids default remains his base assumption, “I think they can take it up to the edge” this time, he said.

It seems “sadly predictable that brinksmanship will go to the final hour” but this time there’s a real risk it continues beyond the point where the Treasury runs out of cash, forcing the government to prioritize debt payments to avoid financial chaos, said Neil Mehta, a London-based portfolio manager with RBC BlueBay Asset Management.

Meanwhile, some investors warn that, just as past performance doesn’t guarantee future returns, the successful conclusion of previous debt-ceiling negotiations shouldn’t spawn overconfidence regarding the way forward now.

“I think markets to some degree have been a little bit inoculated after the 2011 and 2013 and 2015 debt ceilings and to some degree they are complacent,” leaving room for miscalculation, noted Wellington’s Mr. Reganti.

Maryland’s Mr. Palmer said while he continues to expect some resolution, he’s concerned about the brinksmanship. “Every time you play one of these games, if somebody doesn’t blink then you start a fire that’s a little bit harder to put out.”

In the analogy of a high-stakes poker game, “there’s bluffing going on and people are holding certain cards (and they) can miscalculate,” in an environment where a misstep can have enormous spillover effects for capital markets and the economy, said Mr. Reganti.

Impact to escalate

If there’s an actual default, market participants say they expect things to be made right in very short order. How much time they have to do so would be in question, however.

“Almost every hour after that missed coupon or principal payment, things start becoming a train wreck pretty rapidly,” noted Wellington’s Mr. Reganti. With hundreds or thousands of federal payments coming in and out, “the longer you’re delaying on one of them, it starts rapidly piling up,” fast becoming an “operational nightmare,” he said.

Even without a default, the backdrop of debt-ceiling negotiations could set the stage for heightened volatility that significantly impacts big public funds’ asset allocation plans going forward, GSAM’s Ms. Burton said.

For example, if the market sells off in June, hitting public pension funds’ fiscal year and long-term returns through June 30, it could affect their ability to put money into private markets for 10 years, she said.

It could be the difference between board discussions around trimming risk, if returns were good, or adding risk if a portfolio is suddenly trailing its benchmark by 200 basis points, she said.

If there’s a sell-off, a fund’s liquidity will determine how much of a buying opportunity it could prove, she said.

For sell-offs sparked by the ongoing debt-ceiling standoff, Wellington’s Mr. Reganti said if there is a last-minute deal to avert a default, the volatility in the run up to that deal should provide opportunities for investors.

“If it’s going well past the X-date and there is a technical default and there’s ensuing confusion in capital markets, I think you have to probably be a little more careful in terms of the economic fallout, and the longer it goes on, the more likely it is to spread into the real economy … eventually (showing) up on things like valuations and default rates.”

 

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