How to protect against a US default

How to protect against a US default

A common question I am being asked at the moment is 'how can investors protect themselves from the threat of a US default?' The short answer is, with difficulty.  

The problem is default is a low probability, high impact event. High impact because, unless they are considered safe, treasuries have little going for them as an asset class. Low probability because as elected representatives of America it is unthinkable that America’s congress would drive it into a completely unnecessary default. It has never happened before and it would serve nobody's cause for it to happen now: so its unthinkable. 

Nevertheless investment strategy means at least trying to think the unthinkable and so the question again arises. What can investors do about it? Selling out of your investments now has a high chance of a missed gain as the (almost) inevitable last minute fiscal compromise goes through. But instead of trying to avoid the calamity could it make more sense to try and benefit from it? Here we might learn some lessons from special situations investors. 

The rather ubiquitous phrase 'special situation' is used on the names of many mid- and small-cap biased funds that actually just try to buy good stocks. The phrase itself, however, really refers to the moments when investors can capitalise on investors reacting illogically to corporate activity. The classic example is the spinoff. A large company may spin off a smaller division as a separate company. That division may be outside of the company’s core business; it will likely be much smaller than the parent; and as such institutional investors will often sell it regardless. The result is the stock price falls to a low level and opportunistic investors snap it up at a bargain price.

How does this relate to a prospective US debt default? Well, first remember it would be a technical default only. Nobody doubts that payment of interest in arrears would eventually be made. Nevertheless, given that treasuries are renowned as the safest and most liquid assets in the world, still attracting the highest credit rating from two rating agencies, and remain so expensive that they haven’t offered a healthy return for years, a default would surely catch traditional treasury investors off-guard.

Funds owning treasuries, therefore, might well be barred from owning securities in default by the terms of their investment policy. If so investors should watch the treasury prices if a deal doesn’t get done. If forced liquidations on the day of a technical default drive the price down then taking advantage of that misvaluation may well be the best form of defence against an unthinkable outcome.

Guy Foster is head of portfolio strategy at Brewin Dolphin


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