What a Flight From Treasuries Would Look Like

 | Oct 09, 2013 | 4:17 PM EDT  | Comments
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As I wrote yesterday, I do not believe there will be a default by the U.S. Treasury.

If there is a default, however, it would be a voluntary event somewhat similar to residential mortgagors with negative equity strategically defaulting on their mortgages. In that case, borrowers decide to not pay interest due to their creditors, even though they have the financial capacity to do so. This is generally not a good idea, and it is viewed far more critically by future potential lenders than a default resulting from an actual financial inability to meet debt obligations.

The same is true with respect to the impact of sovereign default by the U.S. government. If the Treasury secretary chose such a path, the ability to issue new securities would be affected by some degree of risk having to be priced in that would drive up borrowing costs to the government.

Further, the holders of Treasuries would sue to be made whole and would certainly win that suit.

It is inconceivable to me that the U.S. government officials would choose such a path. Quite frankly, I find the entire issue ridiculous and not worthy of real consideration by investors. If needed, the Treasury and Federal Reserve will get together, keep the government functioning and preclude a default.

Having said that, analysts are discussing some increasing degree of probability of such an event occurring, and logically, the capital markets should reflect this. Usually in a financial crisis, capital flows into sovereign debt drive down yields. But if the crisis is in the sovereign debt market, the potential for a flight from that asset class and into other areas is logical. In this column, I will review some of those.

The first level of institutional transfer would logically be from U.S. Treasuries to agency debt and high-grade corporate bonds. On the agency side, the primary debt would be issued by Fannie Mae and Freddie Mac. Although this may seem counterintuitive, thinking through the process of a flight from Treasuries is a bit like learning to turn into a skid rather than away from it.

Agency debt is typically priced with a risk premium to U.S. Treasuries, because it is not backed by the full faith and credit of the U.S. government. But when that faith is broken, this debt could easily be viewed as less risky than U.S. Treasuries and command a bid that could help agencies' cost of capital fall below Treasury yields.

Although agency debt has no direct backing of the U.S. government, it is collateralized by mortgages that are collateralized by improved real estate and loan payments being made by individual mortgagors. From a logical standpoint, once U.S. Treasuries lack the government guarantee and are on the same footing as agency debt, the diversification of when the debt service comes from (mortgage payments) and the physical collateral (residential homes) should make agency debt preferable to Treasuries by large institutional holders such as insurance companies, central banks and money centers.

An ETF to consider in such a case is the iShares Barclays Agency Bond (AGZ).

On the corporate bond side, the same issues apply, along with the addition of multinational cash flows for the largest companies, most specifically the 30 companies of the Dow Jones Industrial Average.

Within the equity markets, it is logical that there would be a shift to the stocks of companies that are in the segment of the market catering to people basic needs and personal security, i.e., food and guns.

On the food side I continue to like the grocers Safeway (SWY) and Kroger (KR).

On the guns issue, I continue to like Sturm, Ruger (RGR)and Smith & Wesson Holding (SWHC).

There should also be a shift to hard assets such as precious metals and real estate.

On the precious metals side, the stocks of companies that are invested in the metals themselves are safest bet. Two examples are Central Fund of Canada (CEF) and SPDR Gold Shares (GLD).

On the real estate side, the principal way of investing here would be for mortgagors to accelerate their mortgage payoff by making larger payments than are required. 

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