Weighing the Four Ds: Debt Ceiling, Deficit, Downgrade, and Default

With the political debate regarding the debt ceiling and the budget deficit intensifying in recent days, Zane Brown, Lord Abbett Partner, Fixed Income Strategist, looked past the rhetoric at how the potential scenarios may affect Treasury securities, other fixed-income asset classes, the equity market, and the economy. Q. The debate regarding the federal debt ceiling and budget deficit has thus far focused on a deadline of August 2. What are some possible outcomes when a deadline is finally reached? Although the political debate about the debt ceiling and budget deficit are intertwined, the issues should be viewed separately. The potential outcomes of the debate include scenarios where: The credit rating on U.S. debt is preserved at the highest possible level, and no default of debt obligations. This could involve a scenario whereby there is an agreement to reduce the budget deficit by several trillions of dollars over the next decade, while raising the debt ceiling and addressing long-term spending issues, such as entitlement programs. The credit rating on U.S. government debt is downgraded, but a default is avoided. This could occur in a scenario in which the debt ceiling is raised, while the amount of the agreed-upon deficit reduction is a couple trillion dollars, or less, over a shorter period of time. The likelihood increases that Treasuries are downgraded and the U.S. Treasury approaches a default. This may involve a scenario in which there is no agreement to raise the debt ceiling or reduce the budget deficit by the time the Treasury has exhausted its available funds, which could extend beyond early August.

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Should investors be concerned about a default by the U.S. Treasury? Given the serious financial and political consequences of a Treasury default, government officials are likely to avoid this outcome at all costs. Yet, confusion surrounds the issue of default because some observers have confused a failure by the federal government to service its debt with a failure to pay obligations of any kind, including those for Social Security or Medicare. A default, however, refers to a failure to make a payment on a debt obligation. And in reality, the government collects enough revenue every month to avoid such a failure. The Treasury is holding about $83 billion, and it generally receives $200 billion in incoming revenue per month. Meanwhile, debt service in early August would be about $120 billion, including interest and principal payments, therefore, cash on hand and incoming revenues should be sufficient to service the debt past August 2. The federal government has many other financial obligations, however. Among them are entitlement programs, such as Social Security and Medicare. It also must pay federal employees, defense contractors, and a host of other expenses. If the debt ceiling is not raised, the government will not have enough money to cover all these obligations. This means it would have to set priorities.

Because of a defaults serious consequences, servicing the countrys debt would be of the highest priorities. Failure to make a principal or interest payment would result in an immediate jump in interest rates, which would not only make future debt issuance more costly but would also raise borrowing costs for consumers and businesses. This would likely harm the economy as a whole. As a result, a debt default would be an absolute last resort for the government. In a worst-case scenario, the government has another means of avoiding default: it can sell assets in order to service the debt. For example, the U.S. Treasury Department owns approximately $95 billion in mortgage-backed securities that could be sold. If debt payments are covered, asset sales such as this could be used to cover other obligations until Congress can agree to a more permanent solution. Q. A. If U.S. government debt is downgraded from AAA, how low could the rating go? If the United States does not default, but at the same time a budget agreement does not generate enough savings or adequately address long-term fiscal issues, it is possible that the credit rating agencies could downgrade U.S. Treasury securities from their current AAA status. Standard & Poors has taken the hardest line and has said that it could downgrade Treasuries to the AA rangerepresenting a downgrade of one to three notchesif $4 trillion in budget savings over the next decade are not eventually agreed upon. Moodys Investors Service has taken a slightly softer line and has said that, at this point, it is focusing on the debt ceiling portion of the debate in its analysis. The agency said in mid-July that if the debt ceiling is not raised in a timely manner, then it could downgrade Treasuries to the Aa rangealso representing a downgrade of one to three notches. None of the large rating agencies has suggested that a downgrade from AAA to high yield, which would represent a downgrade of nine notches or more, would be an option. Q. If U.S. government debt is downgraded, what are the potential market implications for the Treasury market? Even if the U.S. government debt is downgraded to AA, Treasury securities will still be a distinct asset class when considering the depth, liquidity, and credit quality of the market. Given these sought-after characteristics, it is thought that most investors will continue to hold their positions. For example, U.S. households, corporations, state and local governments, banks, and pension funds held about $3.14 trillion in Treasury holdings as of late July. In addition, the single largest holder of Treasuries, the U.S. Federal Reserve, has about $1.3 trillion in Treasury holdings following its various quantitative easing initiatives. Few of these investors are likely to sell their Treasury holdings even if the credit rating was downgraded. Foreign central banks and sovereign wealth funds, however, may look to diversify their $3.16 trillion in Treasury holdings. While this has been an ongoing trend, the uncertainty over the budget situation has

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likely reinforced the decision for some of these investors, who may diversify into other AAA rated fixed-income assets, such as those issued by Canada or Germany. This continued diversification could push Treasury yields slightly higher and affect the value of the U.S. dollar in the foreign exchange market. Collectively, a downgrade of U.S. debt may not have a significant impact on Treasury rates since AA bonds generally trade about 2530 basis points wider than AAA bonds with similar maturities. The potential increase in yields is most likely to occur on long-term Treasury securities as investors react to the inability of Washington to address long-term spending issues. This would result in a steepening of the yield curve. Q. A. How might a U.S. debt downgrade affect other fixed-income asset classes? Ordinarily, highly rated investment-grade corporate bonds would shadow movements in Treasury securities, thus when Treasury yields rise, the yields on high-quality corporate bonds might also be expected to rise, but to a lesser extent. Yet, there are factors that could increase the demand for high-quality fixed-income securities in the event that Treasuries are downgraded. Some pension plans and financial institutions have a mandate to maintain a minimum average level of credit quality within their fixed-income holdings. These portfolios could see their average credit quality decline toward their minimum target if Treasuries are downgraded. As a result, these portfolios could seek to meet their mandate for minimum average credit quality by selling some of their holdings with low investment-grade credit ratings, such as those at the BBB level, in order to purchase securities with higher credit ratings, such as those at the A and AA levels. The potential price movement on securities with low investment-grade credit ratings would depend on the size and number of the institutions that needed to adjust their portfolios. Given their credit-quality mandates, these portfolios would be unlikely holders of high-yield assets, thus a downgrade of Treasury securities may have a minimal impact on the high-yield credit market. However, it should be noted, that regardless of how Washington resolves the budget situation, there will be a significant, long-term emphasis on reduced spending. This has important implications in the security-selection process given the heavy reliance of some companies, such as those in the technology and defense sectors, in obtaining contracts from the federal government. In terms of municipal bonds, a downgrade of U.S. Treasuries could also lead to the downgrade of certain municipal securities that are backed by U.S. government debt, such as pre-refunded bonds. Although the credit rating agencies have mentioned that some municipalities could be downgraded, most of these are highly rated entities that would still need to balance their budgets by law. About 75% of the municipal bond market consists of securities that are backed by revenues from specific projects that are independent of the credit ratings on U.S. government debt.

Finally, there are some asset-backed securities with structures that provide investors with downside protection that can maintain the highest credit rating in the event of a U.S. credit downgrade. For example, the AAA rating on the senior tranches of some commercial mortgage-backed securities may become increasingly valuable to portfolio managers who need to maintain an allocation of securities with the highest credit ratings in an environment where U.S. Treasuries no longer provide that option. Q. A. What are the implications for the equity markets if U.S. Treasury debt is downgraded? The clearest outcome of the debt ceiling and deficit debate thus far has been the mounting uncertainty, which is often a cause of volatility in the equity markets. Although there could be long-term consequences from the debate, such as significantly reduced government spending, the markets reaction to a downgrade is likely to be short-lived for a few reasons. First, a downgrade may force Washingtons hand to finally reach an agreement that is acceptable to both parties and the credit rating agencies. Its conceivable that the markets would respond immediately to such a resolution even before the rating agencies could react by upgrading Treasury debt back to AAA. Second, as more investors anticipate a downgrade, it becomes at least partially priced into the market, and a subsequent announcement about a downgrade could bring a muted reaction depending on the tone from the rating agencies. Third, and perhaps most important, overall corporate profits generally have been remarkably strong. While there may be an increase in volatility on the announcement of a downgrade of U.S. debt, certain companies may weather the volatility better than other companies. Even in the face of declining consumer confidence, certain companies may grow at their current pace, or faster, even in an environment of reduced government spending and slow economic growth. Companies that could outperform going forward will likely emerge on a case-by-case basis. Industrial stocks havent historically been an area of stability in volatile times, but those industrial companies with international exposure could outperform given the likelihood for more consistent overseas demand and the continued prospects for a weak U.S. dollar. This could also be the case for technology and consumer staples companies that have large footprints in expanding, overseas markets. Yet, investors will need to be increasingly selective going forward, as sectors where they may have sought stability in the past could become emerging pockets of volatility. For example, healthcare companies and defense contractors traditionally have been viewed as safe havens for investors, but these sectors could, in fact, feel the brunt of the government cutbacks. Although there will likely be a positive market response when there is clarity to the plans to resolve the debt ceiling and deficit issues, timing a market responseeither positive or negativecan be a very challenging proposition. Rather than attempting to forecast when a debt downgrade and subsequent resolution may occur, investors may be better served by taking an active approach to gaining exposure

to those well-managed companies that can continue to outperform even in a slowly growing U.S. economy and perhaps capture the growth and currency benefits of non-U.S. markets. Q. A. How could a downgrade of U.S. debt affect the economy? Treasury yields generally serve as the benchmark for a variety of borrowing rates, such as those on corporate bonds, business loans, student loans, and mortgage rates. Therefore, the movement in Treasury yields as the result of a credit downgrade could have an adverse effect on economic growth. Yet, certain areas of the economy, such as housing and the consumer, have been so slow to recover in the wake of the recession that a slight increase in interest rates might not significantly reduce activity in these areas but, instead, only further prolong their recovery. Economic growth would also be affected if the government finds that it needs to prioritize its payments in order to continue servicing the debt. This could mean that some of its bills go unpaid until an agreement is reached on the debt ceiling and the budget deficit. On a longer-term perspective, the emphasis on deficit reduction will lead to spending cuts that can restrict the pace of growth in particular sectors. While much of the recent attention has centered on the nations fiscal situation and the ongoing debate in Washington D.C., the corporate profit story remains quite strong. We are in the midst of another earnings season where, once again, many companies are beating analyst expectations. For the past several quarters, we have witnessed a very positive environment for corporate credit fundamentals: improving cash flows, declining default rates, and broadening access to the capital markets. Q. Where could investors look for opportunity in the event of a credit downgrade of U.S. Treasury securities? Given the strength of the corporate sector, investors may find opportunities in the more credit sensitive sectors of the fixed-income markets, such as certain investment-grade corporate bonds, high-yield bonds, and floating-rate loans. With improving credit fundamentals and attractive yields, these credit sectors may provide an attractive risk-reward profile when compared to Treasury and Agency securities. Tax-sensitive investors may also look to the municipal bond market where defaults have been sliding over the past several quarters, and state and local revenues are rising. In addition, assuming that an investor is in the highest federal income tax bracket, certain municipal securities may offer taxequivalent yields that are above historical equity returns.

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How would a downgrade of U.S. debt affect Lord Abbetts fixed-income portfolios? Several of Lord Abbetts taxable fixed-income portfolios are mainly positioned in securities tied to corporate credit quality rather than U.S. government-related securities. In fact, some currently have little to no allocation to U.S. government securities. While it is difficult to predict exactly how a downgrade would impact other sectors of the bond market, these funds have little or limited direct exposure to these securities.
Bond Debenture Fund 0.2% 0.0% Short Duration Income Fund 1.4% 4.9% Inflation Focused Fund 9.4% 6.2%

Security Type % in Government Related Securities % in Agency MBS

High Yield Fund

Floating Rate Fund

Income Fund

0.0% 0.0%

0.0% 0.0%

0.6% 0.3%

Source: Lord Abbett. Allocations as of June 30, 2011.

A select number of our funds have a larger weighting in government-related securities; however, these allocations are significantly underweight their benchmark.
Security Type % in Government Related Securities % in Agency MBS
Source: Lord Abbett. Allocations as of June 30, 2011.

Core Fixed Income Fund 32.2% 25.7%

Total Return Fund 24.5% 22.8%

The Funds portfolio is actively managed and, may change significantly over time.

Although the controversy over the debt ceiling and deficit reduction has been center stage in the public eye as of late, this is one issue that our investment teams have been looking at for some time. Although the outcome of the current debate and the repercussions from the government actions are unclear at this writing, we believe that our portfolios are properly positioned for the current environment.

Zane E. Brown, Partner, Fixed Income Strategist, is responsible for credit market analysis and strategy, enabling clients to gain context and further understanding about todays credit markets and how they relate to various fixed-income disciplines. He also is responsible for business development in Asia. Mr. Brown, who has more than 30 years of experience in the financial services industry, joined Lord Abbett in 1992 as an Investment Team Leader, and became a Partner in 1996. During his tenure at Lord Abbett, he has been actively involved in the management of various fixed-income and balanced portfolios. He spent most of the past decade as Director of Fixed Income. Prior to joining Lord Abbett, Mr. Brown was an Executive Vice President at Equitable Capital Management Corp., and before that, a Manager in the Bond Department at Brown Brothers Harriman and Co.

He is a former board member of the Fixed Income Forum, an organization of fixed-income institutional investors. Mr. Brown has been featured in The Wall Street Journal, Financial Times, and Pensions & Investments, and is interviewed on CNN and CNBC, among other media, discussing interest rates and Federal Reserve Board policies. In addition, Mr. Brown has been published in the Journal of Behavioral Finance. Mr. Brown received an MBA in investment management from Colorado State University and a BA in management and marketing from Clarion University in Pennsylvania.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Agency securities are similar to U.S. Treasury Bills in that they pay interest and have low default risk. However, the main differences are that they are not backed entirely by the U.S. Government and the interest income is taxed differently. Income from Treasury securities is exempt from state and local taxes. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. High-yielding, non-investment-grade bonds involve higher risk than investment-grade bonds. Adverse conditions may affect the issuers ability to pay interest and principal on these securities. Investments in high-yield securities (sometimes called junk bonds) carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to call, credit, liquidity, interest rate, and general market risks. No investing strategy can overcome all market volatility or guarantee future results. A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest); ratings are subject to change without notice. Bonds rated BBB or above are considered investment grade. Credit ratings BB and below are lower rated securities (junk bonds). High-yielding, non investment grade bonds (junk bonds) involve higher risks than investment grade bonds. Adverse conditions may affect the issuers ability to pay interest and principal on these securities. NR indicates the debtor was not rated, and should not be interpreted as indicating low quality. A yield curve is a line that plots the interest rates at a set point in time, of bonds having equal credit quality, but differing maturity dates. The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. This report does not take into account the investment objectives, financial situation, or particular needs of any particular person. Investing in securities or financial products entails certain risks, including the possible loss of the entire principal amount invested. Investors should consult their own investment professionals regarding their individual investment programs. Shares of Lord Abbett mutual funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including the possible loss of the principal amount invested. Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each funds summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.