Questions, Answers on Debt Debate’s Impact on Investors

With the stalemate continuing between President Clinton and Congress over the federal debt ceiling and the budget, here are answers to questions investors may have about the crisis:

Q: Is there a real risk that the Treasury will default on its debts?

A: For now, no. Treasury Secretary Robert E. Rubin said Sunday that he will take “extraordinary actions” to make sure that the government meets its scheduled interest and principal payments.

It’s expected that Rubin will authorize the “disinvestment” of certain civil-service trust funds that hold billions of dollars in Treasury bonds for future federal retirees. In so doing Rubin would open up new borrowing power for the Treasury, which has nearly reached the current $4.9-trillion debt ceiling imposed by Congress.

*

Q: What exactly is disinvestment?

A: Disinvestment means the Treasury “actually takes back some of the securities owned by the trust fund and gives an IOU to the fund,” says Sung Won Sohn, economist at Norwest Corp. in Minneapolis. That effectively takes those securities off the government’s books, creating new debt capacity within the $4.9-trillion debt ceiling.

*

Q: How quickly will Rubin act?

A: Probably immediately. The Treasury is scheduled to hold its regular weekly auction of three-and six-month bills today, although on Sunday officials hinted that that sale could be postponed.

On Wednesday, however, the Treasury must make $25 billion in interest payments and pay off about $37 billion in maturing bonds. Another $44 billion in T-bills mature on Thursday. So Rubin must be able to issue new debt by Wednesday.

Although some Republicans want to take away Rubin’s authority to tap the trust funds, President Clinton has vowed to veto any such move. As long as he can manipulate the trust funds, Rubin can avoid default for many months.

*

Q: So every owner of Treasury securities will continue to earn interest?

A: Basically, yes. Government bond mutual funds and money market mutual funds, therefore, will continue to accrue interest and credit dividends to their shareholders, just as before. As for the civil-service trust funds, they would have any lost IOU interest credited later, once the budget conflict is resolved.

*

Q: Financial markets have dealt pretty calmly with this crisis so far. Is that likely to continue?

A: Wall Street has generally taken the view that an actual Treasury default is unthinkable because of the global ramifications. The U.S. stock market, which hit record highs late last week, seems to be mocking fears of default.

Even so, last week some investors’ growing nervousness was reflected in a small rise in bond yields and a jump in gold’s price.

The benchmark 30-year Treasury bond yield ended last week at 6.33%, up from 6.27% a week earlier. And gold--the classic refuge for worried investors--gained $7.20 for the week, to $389.60 an ounce, a three-month high.

Some analysts are worried that bond yields will continue to edge higher this week if Clinton and Congress can’t quickly settle their differences over the budget and the debt ceiling.

*

Q: Why should yields rise if the Treasury avoids default?

A: For one, the market will be tested by the huge amount of debt the Treasury will issue once Rubin taps the trust funds.

To cover interest and principal obligations, “the Treasury will have to sell about $60 billion of securities in a short period of time,” notes Paul Kasriel, economist at Northern Trust in Chicago. It isn’t clear yet what type of securities Treasury will offer, but they’ll probably have very short maturities.

There is no question that investors will buy the securities, but the bitter political rhetoric may mean Treasury will have to pay slightly higher yields than otherwise.

One key to the market action will be the demand, or lack of demand, from foreign investors.

*

Q: Why is foreign investors’ attitude important?

A: Foreigners own more than 20% of Treasury debt, a substantial enough chunk to make a difference if many of those investors opted to liquidate their holdings because they’re spooked by talk of Uncle Sam defaulting.

Wholesale liquidation is unlikely, of course, because Treasury securities still are the base upon which world bond and currency markets are built. Many foreign investors don’t have much choice but to own Treasuries because no other market is as deep and liquid.

But some analysts worry that foreigners could hurt the U.S. bond market by simply curbing their appetite for newly issued Treasury securities in the short run.

John Lonski, economist at Moody’s Investors Service, notes that “foreign buying of Treasuries helps to explain much of 1995’s surprising plunge in bond yields.”

Foreign central banks alone now own $482 billion in Treasuries, up $80 billion compared to a year ago. Japan accounted for much of that increase, as it sought to bolster the dollar and weaken the yen.

The point is, U.S. bond yields could conceivably rebound somewhat if a major source of demand--such as foreign buyers--dries up.

*

Q: But couldn’t domestic investors more than make up for any shortfall in foreign demand?

A: That’s what the bond market’s bulls are counting on. Indeed, the bulls believe that any rise in yields stemming from the political war would be a buying opportunity, because they strongly expect interest rates to continue falling once we’re past this crisis.

“When all is said and done, I think we’ll have a decent [federal] budget package with significant deficit reduction” over the long run, says Patrick Retzer, manager of the Heartland U.S. Government bond mutual fund in Milwaukee.

A balanced-budget agreement between Clinton and Congress would then be followed by another cut in short-term interest rates by the Federal Reserve Board, most likely at the Fed’s Dec. 19 meeting, many Wall Streeters say.

(The Fed also meets this Wednesday, but it isn’t expected to take any action on rates while the budget fight is raging.)

The only problem with the still-high level of optimism exhibited by many domestic bond investors is that it doesn’t leave room for error.

If Clinton and Congress can’t settle their differences soon, thus delaying a Fed rate cut past December, markets may react badly. Also, if the dollar were to weaken because of foreign jitters over the budget battle, market interest rates might have to rise to defend the buck, confounding the Fed.