Fidelity’s US Dollar Bond fund considers US debt crisis

Rick Patel, manager of the Fidelity US Dollar Bond fund has outlined his responses to the latest moves in Washington by policymakers to deal with that country’s sovereign debt crisis.

What is happening in the US?

The ratings agencies have sent a warning shot to the US about concerns over their long term fiscal position and gently encouraged them to come up with a deal that will pave the way for the debt ceiling to be raised, thus avoiding a technical default.

As expected, a deal to increase the debt ceiling was struck this week. President Obama has backed the deal to increase US borrowing authority and plans to cut deficits by $3.7 trillion over ten years. Details were scarce but the plan would include an immediate $500bn cut in deficits and include other tax reforms. Spending cuts can notably be expected in the defence sector as well.

What does it mean for bondholders?

This political consensus and swift reaction have helped reduce the probability of a technical default. Such a scenario would have led to an increase in Treasury yields. With other macroeconomic factors (such as the end of QE2 and the European debt crisis) also influencing rates, it is hard to accurately quantify the key driver and wider economic impact.

Following the proposed deal this week, long-dated Treasuries increased with 30-year yields falling by 10 basis points to 4.19% on the news. They backed up again since then, now trading around 4.27%.

Rating agencies are expected to keep negative outlooks in this environment as they are considering all the obligations (including public sectors’ wages for example) of the US Government and not only the ability of the US to pay Treasury coupons.

Is this deal likely to resolve the issue?

The deal proposed by Democrats and Republicans is likely to reduce somewhat the country’s Debt to GDP ratio. However the Government’s structural liabilities will persist notably in Medicare and pensions sectors. It is still to be seen whether or not the reforms will be sufficient enough. My base case is that defaults will be avoided as the US Treasury has the ability to prioritise debt repayments. I also believe that US Treasuries will be well supported at the current levels given the uncertain macro environment and the structural lack of alternatives for both domestic and foreign investors who look for safe heaven investments.

What would happen if the US lost its AAA status?

It is not clear yet if there would be a broad sell-off of US Treasuries. Demand should remain supportive due to a number of factors:

– Banks and insurance companies will continue to hold their Treasury securities as zero risk weighted assets on their balance sheets.

– Foreign central banks will be unlikely to withdraw their holdings given the lack of alternative investments they are facing.

– Further volatility of risky asset valuations may be expected but the US debt ceiling debate is not a new issue and markets have factored this in for a few quarters already.

How are you positioning your fund in this environment?

Credit:

I am underweight the defence sector and sectors linked to possible government spending cuts and overweight tech and pharmaceutical sectors. There have been rumours of a Homeland Investment Act part II being implemented by the Government to allow companies to bring back overseas profits home.

I also have exposure to supranational bonds (eg. World Bank). Back in 2001, when Japan got downgraded from its AAA status, investors favoured supranational entities backed with an average AAA rating and these bonds saw their yields spreads tighten relative to Japanese Government Bonds.

Other:

My exposure to the US Treasuries is 33.6%. The fund is slightly long duration vs its benchmark (+0.31 years). Uncertainty in the macro outlook for the rest of the year may well lead to further flight to quality and a fall in Treasury yields. Some market participants have already cut their real GDP growth forecasts for Q3 this year. Meanwhile, US corporate exposure is of high quality and very diversified.

 

Country Sector Total
US Treasury 33.6%
  Communications 8.0%
  Consumer Non Cyclical 6.2%
  Banks & Brokers 4.4%
  Consumer Cyclical 3.1%
  Quasi / Sov / Supra / Agency 2.9%
  Insurance 2.5%
  Other Financials 2.2%
  Energy 2.1%
  Capital Goods 2.0%
  Utility 1.9%
  Technology 1.5%
  Transportation 0.1%
US Total   70.6%

The rest of the fund is exposed to non-US country risks.

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