Debt Ceiling Talks, Again

Jeffrey Addis:

Welcome to our podcast. My name is Jeffrey Addis. I’m the chief operating officer of Merganser Capital Management. Before we begin, a few important regulatory disclosures. This presentation is for informational purposes only and should not be considered as an investment advice or a recommendation of any particular issuer, security, strategy, or investment product. Now on to our podcast.

Mike Cloutier:

Hi, everyone, and welcome to A Bird’s Eye View of the Bond Market podcast with Merganser Capital Management, where we invite leaders from our investment team to offer their analysis on the US investment-grade bond markets and insights into key economic developments. My name is Mike Cloutier, chief marketing Officer for Merganser, and I’ll be hosting today. We’re recording this episode on Tuesday, January 31st, 2023, and I’m thrilled to be joined by our very own chief investment officer, Andy Smock. Andy is responsible for the overall leadership of our investment team and serves as portfolio manager on our longer-duration strategies. Welcome, Andy.

Andy Smock:

Thanks, Mike.

Mike Cloutier:

It’s been an eventful start to 2023. Among many topics, the debt ceiling is once again on the spotlight as one of the key risks facing fixed income markets this year. Andy, can you briefly explain this concept for our listeners and describe the current state of affairs?

Andy Smock:

Sure, and as you said, it’s one of the key risks. Foremost on my mind are the Fed and slowing growth, but the debt limit’s one of those things that creeps up, and when it comes to face investors, especially within the last couple of weeks, it becomes a big deal. So the debt ceiling is a self-imposed statutory limit on the authority of the US government to borrow money. So that’s a key distinction, it’s not seeking authority to spend more. Congress has already done that. We’ve already spent the money. It’s already been approved, and this is simply borrowing money to pay for all those obligations. So an obvious question is, why are we doing this to ourselves if it’s self-imposed? And it’s a hard one to answer, but mostly it’s about politics and leverage. If you’ve got veto power over this huge event, it gives you leverage in order to negotiate. In this case, it’s about future spending levels.

Mike Cloutier:

It’s my understanding now that extraordinary measures have been implemented, and that occurred recently about a week ago, I think. Can you explain the options that the Treasury has under this?

Andy Smock:

It really ties back to the fact that the debt ceiling is a limit on borrowing, not on spending. So as long as the Treasury doesn’t need to borrow more than already planned, it can find money to pay debts and can continue to do so. So there are a lot of different programs out there that they’re able to, defund isn’t quite the right word, but defer spending on, and really it’s about writing IOUs to various government programs and payments that are not critical, a lot of retirement programs and others. So the extraordinary measures really amount to diverting cash flow, turning that spigot into a different direction. It doesn’t actually reduce any of our liabilities. It defers them for the future. We’ve got a lot of experience doing this because this is the sixth or so time that we’ve hit this limit, that it is almost a regular course of business now to divert funding to these extraordinary measures. I think, actually, the name itself is a misnomer now. They’re now a normal part of the debt ceiling process.

Mike Cloutier:

How should our clients and investors more broadly think about supply in the near term over the next six or so months?

Andy Smock:

If past experience is useful, then it shouldn’t change that much. The government has a plan to issue bonds. It’s all part of increasing towards that debt limit. I don’t imagine that supply will be materially impacted. I think demand might be as you get closer, and we can talk more about this in a minute, but as you get closer, you would certainly, on the margin, prefer a T-bill that matures a week before the debt limit rather than a week after. Usually, you don’t see that market of a difference over a one-week period.

Mike Cloutier:

So based on everything we know right now, and I think some dates have been thrown around out there in various publications, but when will the Treasury exhaust the emergency funds and be unable to meet its obligations if it comes to that?

Andy Smock:

As you mentioned, we’re already in the extraordinary measure period, and it’s an interesting thing that there are a range of forecasts, and sometimes it’s hard to figure out why. It’s just math. Why can’t we predict with certainty? And part of it is that we are in tax receipt season for the US government, so they are getting tax returns right now and they’re issuing refunds. So it’s a lot of cash flow going on in the background that is difficult to predict. In particular, we’re in a time right now where the Fed is trying to slow economic growth, tax receipts are very sensitive to capital gains and other income measures and unemployment measures. So no one really knows when they’ll run out of the ability for these extraordinary measures to continue. But most forecasts are from mid-June to late August as the range, and as you get closer, you’ll know more.

Mike Cloutier:

So we know that a lot of this comes down to political brinkmanship and each side bartering for their own position. But what happens if Congress can’t reach a deal to raise the debt ceiling? Not that we’re calling for that, but what is your expectation there?

Andy Smock:

So there’s a lot we don’t know that we will speculate on. What we do know, or what I at least believe, is that It’ll send markets into chaos, huge unknowns, huge uncertainty, and a full range of outcomes will be beginning to be priced in by the markets. It is possible that choosing to default on the debt isn’t even constitutional since the 14th Amendment states that the validity of the public debt of the US shall not be questioned. But that doesn’t help us in the short run because this is a political decision. We passed that deadline, and it would take months for courts to adjudicate on that. It might help us in the future, but it won’t help us in the short run. Ultimately, if we reach the deadline, we still may be able to meet our obligations. There’s ways to prioritize certain payments.

The Treasury hates that. They won’t even talk about it because they don’t want that to become the next layer of extraordinary measures. They want things to be worked out appropriately by Congress, so no one really knows. You think about the day or two after. Suddenly, it doesn’t mean the Treasury has run out of money entirely. It just means they’ve run out enough money to pay for everything that’s due. Prioritization is a logical outcome from that, but that still could mean a default or a downgrade, at least of the US. Even if we’re paying all of our treasury coupons and principle, there are still other programs out there that we owe money to, contractors that we owe money to. If you’re not making true on your obligations, that could still be a downgrade, if not a default. So we get into a very murky territory, and I think the rating agencies are going to vary wildly on their interpretations in that couple week period following the deadline.

Mike Cloutier:

That leads me into my next question, and you’ve actually partially addressed it already, but the last time we were here was 2011. There was a downgrade of the sovereign rating by S&P. I think from my standpoint and our listeners, it’s interesting to just reflect and think about how markets could react, what lessons we’ve learned from that period, and what should fixed-income investors be thinking about as we enter that period.

Andy Smock:

So looking back at 2011, the two primary things going on at that time were the Greek debt crisis and this debt limit, which no one at that time really expected would hit the level that it did or the urgency we got down to the very final days or hours and a deal got passed. But that actually didn’t rattle markets as much as the downgrade by S&P to AA-plus. That was the catalyst. If you parse through what they said, it was not that the US had a diminished capacity to repay debt, only a diminished willingness. That’s really just the legislative process. We have a tremendous capacity to repay our debts. It is really not in question by anybody. It’s just that legislative process and it’s that dysfunction that they downgraded the US for.

So what happened? We saw a couple of things happen. I’d mentioned Treasury bills. There was a spike in yields for those that are maturing right before to right after, and that is before even we had all the chaos of the downgrade. So I think that is going to happen again. As an investor, I certainly would prefer to have a Treasury bill that matures before the… Or I want nothing maturing right after. I don’t want to be in that confusion zone, if you will. Spreads and fixed income widened a lot right after the downgrade. I mentioned there’s the Greek debt crisis too, so it’s hard to exactly attribute to which it was. But if you look at the calendar, it’s pretty clear that corporate spreads were significantly impacted. In order of magnitude on the Ag, corporate spreads on in IG, corporate spreads went from about 150 to 250 basis points in the two months.

100 basis points in two months after that, and they remained elevated and volatile for a full year following. So it wasn’t like they just snapped back. It was a very sharp slap on the face. The second is that, logically, you would expect that Treasury yields might increase after a downgrade. You see that in corporates all the time. Ratings go down, credit risk goes up, spreads go up because you need to be compensated more for that risk. With the Treasury, that didn’t happen. The reason that I believe it didn’t happen is because when you get your risk-free rate downgraded, then the risk of everything else goes up. The natural reaction to investors is a flight to quality. Like it or not, still the most stable, liquid, deepest market was the US Treasury. So there was a flight to quality, and folks bought treasuries across the curve. The 10-year Treasury was hovering about 3% before the downgrade, and then after that, it dropped at 2.1, 90 basis points. So interestingly, it completely offset the corporate spread widening. 100 basis points in one direction, 100 basis points in another.

Mike Cloutier:

So your total return experience was relatively flat.

Andy Smock:

That’s right. But you wanted to be in Treasury and you wanted to be long-duration. If you look through all that and apply that to today, what does that mean? It means the risks are heightened. On one hand, everybody remembers that period and what happened. Interestingly, I look at the markets today, and they look way overbid. They look too expensive. You’ve got a slowing economy, you’ve got the risk of a Fed, you’ve got this low probability but high impact risk of the debt ceiling debacle. It just doesn’t seem like the market’s pricing any of it in. Maybe that’s because there’s been a lot of flows into ETFs and there’s a lot of demand for fixed income. Maybe it’s because bonds are back, and all those things are true. But I would still rather own higher-quality liquid securities right now and rotate into the volatility when it comes at better prices. So the market is not worried. It’s getting a lot of headlines, but we’re not seeing it flow through to spreads yet. But I expect it to.

Mike Cloutier:

That’s going to do it for today, Andy. Insightful as always. We especially want to thank our listeners for listening to A Bird’s Eye View of the Bond Market, and we look forward to speaking with you soon. Thanks again.

Jeffrey Addis:

This commentary contained or incorporated, by reference, certain forward-looking statements, which are based on various assumptions, some of which are beyond our control. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. No part of this presentation may be reproduced in any form or referred to in any other publication without the express written permission of Merganser Capital Management. For more information, please visit our website at www.merganser.com. Thank you.