The fixed income team at American Century Investments, represented by senior vice president and senior portfolio manager Robert Gahagan, believes it’s highly unlikely that the U.S. government will miss any of its scheduled debt payments in coming months, or that related market uncertainty and volatility will cause our money market funds to “break the buck” (be forced to transact share purchases and redemptions at prices less than the usual $1 per share).

To help explain market behavior under unstable conditions, we often repeat the following adage: “investment markets hate uncertainty.” We tend to be leery of uncertainty because it can trigger investor skittishness, irrational behavior, and volatility.

We’re definitely seeing that this summer. Unfortunately, considerable uncertainty is weighing on the markets, including questions about the strength and sustainability of the economic recovery, which we addressed in our last update (“We See This Slowdown as Temporary Too,” Weekly Market Update, July 12, 2011).

Our Domestic Debt Ceiling Debate

Other unsettling factors include the severity of the European sovereign debt crisis, and, closer to home, our domestic debt ceiling debate—whether the rival factions within Congress and at the White House can put aside their federal budget deficit reduction differences long enough to enact compromise legislation that would “lift the debt ceiling.”

Such a compromise would authorize the issuance of more government debt beyond the present ceiling (limit), which would allow the U.S. government to cover the sizeable shortfall between available revenue and required payments, and meet its immediate financial commitments to borrowers and other creditors.

Too Much at Stake for an Agreement Not to Be Reached

We still believe the opposing factions can reach some sort of compromise and that they will eventually come to an agreement before a government default (missed scheduled debt payment) occurs.

We believe this because the consequences of not reaching an agreement are so high—there’s simply too much at stake politically, economically, and in the capital markets to allow the U.S. Treasury to default on any of its debt payments.

No one in Congress or the White House wants to be held responsible in the public eye for missed payments on debt or entitlement programs, the U.S. losing its AAA credit rating, and/or any rising interest rates and debt service costs that would likely result.

Mounting Pressures from Ratings Agencies

Speaking of the U.S. potentially losing its AAA rating, the major credit ratings agencies are getting into the act and applying pressure, helping to focus necessary attention on fiscal responsibility and austerity.

Three months ago, back in mid-April, Standard & Poor’s (S&P) grabbed the financial markets’ attention. As it affirmed its AAA long-term rating on U.S. government debt, it also changed its U.S. rating outlook from stable to negative, the first time it had ever done so.

On July 14, it went a step further, indicating that there is at least a 50% chance of a downgrade in the next 90 days if talks between Congress and the White House remain stalemated. On a related note, on July 13, Moody’s Investors Service placed its Aaa U.S. rating on review for a possible downgrade within three months. We view these rating agency actions as “warning shots across the bow,” with the intended result of getting the U.S. to lower its deficit and debt levels.

Though the Congressional stalemate continues, the warning shots seem to be working. A fiscal austerity wave appears to be sweeping the globe, and the U.S. finally seems to be catching it. The extent to which austerity measures are being debated in Congress—as well as at the state and local government levels—is remarkable, given the lack of progress in the recent past. We seem to be turning a corner here.

Tax Revenues More than Enough to Meet Debt Payments

And, on a further optimistic note, let’s clarify something: Even if the debt ceiling is not raised by the U.S. Treasury’s August deadline, that doesn’t mean that we’ll see defaults on U.S. government debt. The government is currently receiving more than enough federal tax revenue to meet its debt service payments.

Debt service represents a significant slice of U.S. government spending, but it’s far from the biggest slice. In our view—a view that’s shared by other respected bond market professionals—the government will honor its debt payment commitments to investors first and will cut or delay other payments if the debt ceiling is not raised.

Missed payments of any type would likely still result in U.S. credit rating downgrades (both a debt ceiling agreement and a deficit reduction plan appear important to the rating agencies for maintaining a long-term top rating), but not to the extent that a full-blown Treasury payment default would.

We View Market Volatility as a Bigger Threat than Default

Frankly—returning to how we began this article—we view the possible market volatility resulting from the debt ceiling uncertainty as a bigger potential threat than a default.

As the debt ceiling debate drags on, uncertainty and unrest are likely to increase, with potential correspondingly negative impacts on the financial markets, including both equities and fixed income.

We had a taste of that potential impact on Treasury yields at the end of June, when the benchmark 10-year Treasury note yield jumped from 2.86% at the U.S. market close on June 24 to 3.18% at closing on July 1. However, much of that Treasury selloff was due more to the stock rally at the end of the quarter and a rebound in riskier investments in general (responding to the financial relief agreement in Greece) than it was over debt ceiling concerns.

But that possible market reaction threat remains. If the White House and Congress inadvertently create an impression that the U.S. may even temporarily miss a debt service payment, the fixed income market is likely to respond with falling prices and higher yields.

“Breaking the Buck” Would Require an Extraordinary Rate Increase

One area where we’re evaluating and monitoring that threat very carefully is in the money market arena, where a sudden sharp rise in interest rates could theoretically cause money market funds holding a high percentage of U.S. government debt to “break the buck.” That’s the hypothetical bad news.

The good news is that—given regulatory maturity limits on money market funds and other factors—it appears that it would require an extremely large market reaction (something in the neighborhood of an immediate 300 percentage point increase in money market yields, pushing them from near 0% now to over 3% over a very short time frame) to cause these funds to break the buck.

We view such an extreme market reaction as highly unlikely, similar to the low percentage chances we give to a Treasury default. We strongly believe that enough professional market participants share these non-default views, and that enough “cool heads” will prevail to help prevent money market yields (or other fixed income maturity yields, for that matter) from reactively oscillating that much.

To put a 300 percentage point money market yield increase into recent historical perspective, even during the depths of the 2008 financial crisis, the biggest increase in the benchmark three-month U.S. Treasury bill yield, from one trading session to the next, was 65 percentage points, from 0.43% at the U.S. market close on October 16, 2008, to 1.08% at closing on October 20. Though past performance is no guarantee of future results, we believe 300 percentage points would be an extraordinary increase.

Closing Thoughts

Reaching back into the history books again, President Franklin Roosevelt coined another market adage during the depths of the Great Depression when he said: “The only thing we have to fear is fear itself.” We view potential market volatility stemming from debt ceiling uncertainty as a far bigger threat going forward than the small amount of default risk.

This is remarkably similar to what we saw in the municipal bond (muni) market earlier this year. That was when “headline risk” caused by overdramatic muni default projections triggered more market turmoil than any actual defaults (which still remain at relatively low levels, despite all of the recent anxiety).

The bottom line is that we still think a debt ceiling extension agreement will be reached, and even if it doesn’t happen immediately, the U.S. government has sufficient revenues to meet its debt payments to investors—it’s other government payments that will be cut or delayed. We don’t believe there will be any U.S. government debt payment defaults this summer. And we also believe there’s a significant ability on the part of money market funds to absorb higher interest rates caused by any market uncertainty.

 

 

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: Individual Investors | U.S Investment Professionals

An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund.

The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

You should consider a fund’s investment objectives, risks, and charges and expenses carefully before you invest. The fund’s prospectus or summary prospectus contains this and other information about the fund, and should be read carefully before investing. Investments are subject to market risk.

 

 

(c) American Century Investments

www.americancentury.com

 

 

Remember, if you have a question or comment, send it to .