Some seek silver lining, some an escape

July 27, 2011

If the showdown over the debt ceiling ends badly, it could be good for some investors. They might get a long-awaited chance to snap up stocks and bonds at bargain prices.

“Chaos creates opportunity,” said Stewart R. Massey, chief investment officer at Massey, Quick & Co., which helps endowments, foundations and wealthy families manage more than $3 billion of investments.

If the stock market plunges by more than 10 percent, “we would start to be fairly aggressive buyers,” Massey said.

With less than a week remaining before the U.S. government could default on its debt, some investors are thinking about worst-case scenarios, and as they see it even a disaster could have a silver lining.

“You always want to buy when there’s blood on the Street,” said David W. Fenstermaker, a financial adviser at Raymond James.

According to one school of thought, the political deadlock and the shock to the market would be temporary, even if there are lasting effects.

Until this week, investors around the world had generally shrugged off the drama in Washington as the inevitable prelude to a last-minute deal, taking it for granted that the politicians would avert a disaster.

But anxiety is spreading, and some investors are running for cover.

A so-called fear index known as the VIX, which measures expected volatility in the stock market, rose to 27.98 on Wednesday, up from 17.52 on Friday, before a breakdown in negotiations between President Obama and House Speaker John A. Boehner (R-Ohio). The index is based on bets investors are placing that stocks will move sharply.

The cost of hedging against a default on Treasury bills has also leapt. A one-year insurance contract on $10 million of debt soared to $80,000 Wednesday from less than $23,000 on May 17.

Investors were paying more Wednesday to insure against a loss on U.S. debt than they were to hedge against a default by Turkey, Thailand, the Philippines or the Slovak Republic. The cost was about four times the price for British debt, almost twice the price for Russian debt, and more than double the price for IOUs issued by Panama.

Increasingly, investors in garden-variety stock mutual funds have also been heading for the door.

Outflows from long-term stock mutual funds totaled $6.8 billion during the week that ended July 20, the Investment Company Institute reported Wednesday. That was nearly double the prior week’s total, and it was before the debt ceiling showdown entered a more perilous stage.

One of Fenstermaker’s clients telegraphed his intentions Monday morning, as markets reacted to the blowup between Obama and Boehner.

“If gridlock in Washington causes the stock market to take a big hit this week, I will be a buyer,” the client, an accountant in his 60s with two children in college, told Fenstermaker by e-mail.

By late Wednesday afternoon, Fenstermaker was helping another client craft a plan to liquidate a chunk of her retirement savings, the financial adviser said. That client, a Washington lobbyist, was panicked about the latest developments and looking for “a time out,” Fenstermaker said.

With investors increasingly tuned in to the debt negotiations, some say there is little they can do to prepare for a bad outcome. Not only do they view it as improbable, but the consequences could be far-reaching.

“It’s a bit like a nuclear bomb going off in your home town,” said hedge fund manager Dinakar Singh of TPG-Axon Capital. “My guess is it’d be pretty hard to hide from that.”

U.S. Treasury bonds have long been considered the safest of investments. They are part of the bedrock of the banking system, making up much of the capital that banks hold to support their lending. They serve as collateral for complex transactions between corporations, and as a haven for the risk-averse.

If their bankability is suddenly in doubt, investors ask, what’s the alternative?

“I can’t think of a risk-free asset left that would not be impacted by a default,” said Michael C. Schlachter of Wilshire Associates, who advises big pension plans.

Brian Reid, chief economist at the Investment Company Institute, said the mutual fund industry group has heard from members that money market funds have been working to become “more flush with cash” as securities they hold mature.

That could help them handle customer withdrawals in a crunch.

Investors have also become increasingly reluctant to hold Treasury bonds that mature in early August. The Obama administration has said the debt ceiling must be raised by Aug. 2.

Yields on Treasurys that come due in early August are more than twice as high as yields for comparable bills maturing in September, meaning that investors are demanding higher interest rates on federal IOUs that are seen as more likely to be affected by any disruption.

The scarcity of alternatives leads some analysts to predict investors generally will stick with U.S. government bonds even if the government defaults.

But the fact that so many investors are still counting on a political compromise could make the reaction even sharper if they’re wrong.

Institutions and other investors sitting on cash could seize the moment by buying assets at discount prices. Others could face tantalizing frustration, like homeowners longing to trade up in a depressed market but unable to buy a new home until they sell the one they already own.

Staff writer Neil Irwin contributed to this report.

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