Preparing for worst as debt-limit talks drag on

With debt-ceiling deal elusive, investors look for hiding places, and find precious few

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Bernard Condon, Matthew Craft and David K. Randall, AP Business Writers, On Monday July 25, 2011, 6:28 pm EDT

NEW YORK (AP) -- Scrambling to protect themselves against a U.S. default, investors are buying gold and foreign currencies, using derivatives to bet on a stock market collapse and taking out complicated insurance policies.
They may want to consider crossing their fingers.
If the United States suddenly stiffed its creditors, the impact would be so widespread, complex and unpredictable that it is next to impossible to shield against steep losses, experts say.
A default could cause turmoil in the stock and bond markets, plus a replay of the fear that froze lending in the depths of the 2008 financial crisis. In the chaos, investments you'd think were a sure bet to fall might rise instead, and vice versa.
Consider the assets at the heart of the crisis -- Treasury bonds. You would expect interest rates on Treasurys to rise the closer Washington gets to missing a debt payment. Investors would demand higher rates because of the greater risk they wouldn't get their money back. After Argentina defaulted in 2002, foreign lenders required higher rates.
But some bond traders are betting the opposite will happen. They think nervous money managers could rush into Treasurys if Washington blows past the Aug. 2 deadline to raise the debt ceiling. The buying would push interest rates lower.
The logic behind this seemingly illogical reaction: Treasurys are widely traded around the world, with plenty of buyers and sellers ready at a moment's notice, a quality known as liquidity. Investors like that, especially in a crisis, and may overlook fears of missed payments.
Gifford Combs, a portfolio manager at Dalton Investments, which manages $1.3B in assets, has been buying short-term Treasury bills for this reason. But he concedes he's not sure what could happen in the event of a default.
"If there is a financial meltdown and panic, you don't know where investors will go," he says.
A second reason to like Treasurys: A default could help sink the economic recovery. Dan Greenhaus, chief global strategist at brokerage BTIG, thinks Washington is likely to continue paying interest on its bonds, keeping creditors happy even if it means gutting other government spending. The massive drop in government spending would then drag down the economy. And when economic growth looks grim, traders turn to Treasurys.
"No matter what happens, Treasurys are still the safe haven," Greenhaus says. "No other market is as large or as liquid."
Some investors are hoping high-quality corporate bonds serve as a backup safe haven. Wilmer Stith, the portfolio manager of the $3 billion MTB Intermediate-Term Bond Fund, has been buying bonds of companies like IBM and Microsoft that have strong balance sheets and high credit ratings.
Others are seeking protection in credit default swaps, the insurance policies that pay off if a company or country defaults on its debt. The cost of buying protections against a U.S. default has been rising fast, reflecting high investor demand.
To insure $10 million worth of Treasurys for a year, investors now have to pay almost $50,000 -- double what it would have cost them just two months ago. That's about what it costs to insure an equal amount of bonds issued by Russia.
As with bonds, stocks could be thrown into turmoil in a default.
To help protect his clients, Stuart Speer, a financial adviser at Heritage Advisors in Overland Park, Kan., has bought "puts" for shares that track two stock indexes -- the Standard & Poor's 500 and the Dow Jones industrial average.
The "puts" give him the right to sell those shares in the future at roughly today's prices. So if stocks tumble on a U.S. default, his clients can buy shares at low prices, sell them for the locked-in higher prices and pocket the difference. Those profits will help offset any losses they face from their own stock holdings.
Speer thinks the odds of default are slim -- but he's still worried. "If the U.S. defaults, it could be a calamity," he says. "People will lose confidence in the markets."
Here are some other indicators to watch in the coming days for clues on how investors are getting ready for a U.S. default.
-- Treasurys: How will you know if China, the largest foreign holder of Treasurys, loses faith in the U.S. government? Bond yields will leap. The main Treasury to watch is the 10-year note. Its yield acts as a floor for mortgages and other lending rates throughout the economy. Everybody has been watching for signs of panic, but the market has remained calm so far, responding instead to worries that the economy is slowing down. The yield has hovered below 3 percent since June.
-- Gold: Investors are piling into gold on fears of a U.S. default, pushing the metal on Monday to $1,612 per troy ounce. But unlike a lot of metals, including silver and copper, there are few commercial uses for gold. That makes it difficult to guess just how much it really is worth, and whether the price rally will continue. But its high price is a good indicator of how scared people are.
-- Stocks: Concerns about the debt ceiling haven't hampered the stock market yet. The Dow Jones industrial average twice jumped by more than 100 points over the last week thanks to strong corporate earnings from Microsoft, IBM and Coca-Cola. But most market analysts think a deal will be reached and haven't laid out a strategy in case it's not. "I don't know how you could trade this in the short run except for waiting for greater clarity," says Jonathan Golub, chief market strategist at UBS.
-- Mutual funds: Everyday investors do not appear to be making drastic changes to portfolios. In the week of July 13, the last week of data available, investors pulled $4.1 billion out of funds that invest in U.S. stocks, according to the Investment Company Institute. Investors pulled $4.5 billion the week before, continuing a pattern of selling that dates back to May. Bond investments followed the same pattern. Investors moved $4.8 billion into bond funds in mid-July, a slight decrease from the $6.1 billion put into bonds the week before.
-- Currencies: Monty Guild, head of Guild Investment Management in Los Angeles, says he's trying to protect clients by buying currencies issued by countries that have been more prudent with spending. His top choices: Singapore dollars, Canadian dollars, Brazilian reals and Australian dollars. The bet is that as the U.S. struggles to pay its debts, more investors will put money in these countries, lifting the value of the currencies.