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History Repeating? Debt Ceiling May Call for a Portfolio Check

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October 9, 2015

With its budget patch, the federal government keeps the lights on to start the new fiscal year. Now the real work begins. For investors, Washington’s tough budget negotiations—and the bigger challenge of a debt-ceiling revamp—are additional factors that appear to be keeping potential pressure on interest rate markets.

These politically charged budget and debt talks so close to an election likely invite volatility into stock and bond markets that are already hinged to Federal Reserve decision-making (we took a look at how volatile markets performed during the debt ceiling crisis of 2011).

The Fed is trying to decide when to remove ultra-loose interest rate policy that’s been in place since the recession, but that’s a task complicated by global economic vulnerability and a U.S. job market that’s growing but running below potential. It appears that the Fed wants to maintain a go-slow, flexible interest rate response to changing market conditions. Any unanticipated mark on the reputation of “safe haven” U.S. bonds as the result of Washington’s debt and budget troubles isn’t likely to make the Fed’s job any easier and could leave investors pondering again how best to position their portfolios.

Where Do We Stand?

Congress negotiated—and the President signed—a stop-gap measure to extend federal funding until December. Republicans and Democrats now have around 10 weeks to formulate a long-term budget, with the sides looking to strike a two-year deal.

Meanwhile, Congress has until around November 5 to raise the $18.1 trillion debt ceiling and avert a default. The deadline is sooner than most budget analysts thought just a short time ago.

Is This Time Different?

The debt limit has been politically explosive over the past few years, with Republicans keen to limit spending as well as take back the White House and Democrats also digging in during what’s been a greatly divided congressional session. Now, it’s also true that even with all the drama, Congress has historically agreed to the necessary deals in time. A guarantee? Of course not.

The risk of a U.S. debt default typically means that investors will demand higher yields (aka higher interest rates) to compensate for the unforeseen risk. The Fed appears to have a bias toward higher rates right now, but any added lift from market-influenced interest rates could toss the Fed off plan.

Time to Reassess?

If you’re thinking about buying bonds or bond funds, or have recently added a fixed-income component to your diversified portfolio, you need to be aware of the potential impact from rising rates on your holdings. And that means you may need to care about the outcome in Washington.

When bond market rates head higher it lowers the value of existing bond holdings. A rising-rate environment could potentially compromise the fiscal health of companies who are making the payments on the corporate bonds . And  for publicly traded financial companies, the implications for their own bond holdings and bond trading may also matter to how those stocks perform; as a general rule of thumb, bank loan margins—and potential bank profits—can improve with higher interest rates.

If interest rates go up and you need to sell your bonds before they mature, be aware that their value may have gone down and you may have to sell at a loss, all else being equal. If you buy a bond and hold onto it until it matures, which many investors do, rising rates won’t change the income payments you receive. At maturity, you get back par or face value, having collected interest along the way. Don’t forget about credit or default risk—the risk that an issuer can’t honor its principal and interest payment obligations—may still factor regardless of interest rate swings.

There’s an important distinction between bonds and bond funds, especially in a changing interest rate climate. Bond funds don't have a set maturity date. You may find that when you need to get your money back, you have to sell your piece of the fund, and that piece may fetch a lower price than you initially paid. The value of bond funds can be greatly influenced by inflows and outflows, too. That means liquidity, perhaps driven by confidence in U.S. debt market health, can strongly affect bond funds’ fate.

No matter the political, budgetary, or interest rate climate, bond holdings in all forms typically remain  a part of a diversified portfolio. But, as with any investment, there can come a time when risks once considered in the abstract may become reality. Washington has been known to deliver a reality check from time to time.

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