Perspectives on U.S. debt

Delaware Investments portfolio managers comment on the U.S. debt ceiling as well as the nation's longer-term fiscal challenges.

Frank Morris

Francis X. Morris 

Senior Vice President, Chief Investment Officer – Core Equity

Macroeconomic forecasts typically do not play a meaningful role when we construct our portfolios. However, a downgrade of U.S. government debt, or a default, would clearly weigh on our growth outlook for the United States as well as other economies across the globe. Either event could lead to challenging equity market conditions over the near to medium term.

A big part of our investment process involves allocating capital to companies that we believe have superior business models, attractive long-term growth potential, and strong balance sheets, as well as those that we believe can outperform their peers in a slow-growth economy or in an environment where access to outside financing is limited. With this framework in mind, we feel comfortable with the way we are currently positioned, and we look to use any widespread selloff in the market as an opportunity to invest in companies with solid long-term earnings growth prospects that are trading at what we believe are attractive valuations.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Investments in small and/or medium-sized companies typically exhibit greater risk and higher volatility than larger, more established companies.

Roger Early

Roger A. Early, CPA, CFA, CFP 

Senior Vice President, Co-Chief Investment Officer – Total Return Fixed Income Strategy


Paul Grillo

Paul Grillo, CFA 

Senior Vice President, Co-Chief Investment Officer – Total Return Fixed Income Strategy

With the feedback we have been hearing from the various factions in Washington, D.C., the probabilities seem to be growing that U.S. government debt will get negative rating actions from one, if not two, of the major rating agencies in the near future. To address the risk of further downgrades, the United States will likely be forced into focusing on austerity measures to confront the negative capital markets reaction that, to us, seems sure to follow.

Given the severity of the government's financial situation, a partial budget plan cure would not, in our view, last long and would need to be revised to include further cuts in spending or increases in revenue, or both, to help close long-term budget gaps. While, in our opinion, this would be good for the long-term competitive position of the U.S. in the world economy, in the short term it would likely continue to bring economic challenges to our nation, as well as to many of the other developed nations that face similar fiscal challenges.

Within this environment, we continue to position the Funds we manage for a challenging economic environment and a very slow and troubled recovery (both domestically and in the euro zone). Our emphasis on higher-quality income investments continues, as we feel this is a time period in which investors should emphasize the return of capital, and not the return on capital.

Across our diversified funds:

  • Our international investments continue to concentrate on developing countries that offer natural resources or competitive labor advantages as well as those that we believe offer credible fiscal and monetary policy.
  • In the developed world, the characteristics we seek are much the same. Our core investments include Australian, Norwegian, and Canadian government bonds. These countries have similar characteristics in that they are natural-resource rich, and have exercised good fiscal discipline in covering their populations with social or savings safety nets.
  • We maintain a core investment in the high grade corporate sector, where credit fundamentals have continued to improve since the recession's end. We maintain an overweight allocation to the finance sector, mostly in domestic bank and finance companies, which are partially hedged with insurance protection on the European banking sector.
  • We have hedged some of the Funds' investments in the high yield bond sector.
  • We have small exposure to U.S. Treasury debt. The Funds also have exposure to agency mortgage-backed securities (MBS) for their added yield potential.

The fiscal challenges facing the U.S. and euro-zone countries are significant. Add to this the tightening of monetary policy in emerging nations, and you have an environment in which conservative income funds, in our opinion, may reduce investor portfolio volatility and possibly hedge against risk-market selloffs. In our view, this is not a time to take a chance on peripheral European debt and try to calculate how many pennies you could get back on your dollar of investment. We believe this is a time for caution and conservative investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer's ability to make interest and principal payments on its debt.

Fixed income securities may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by a Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.

High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds. The high yield secondary market is particularly susceptible to liquidity problems when institutional investors, such as mutual funds and certain other financial institutions, temporarily stop buying bonds for regulatory, financial, or other reasons. In addition, a less liquid secondary market makes it more difficult for a Fund to obtain precise valuations of the high yield securities in its portfolio.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

If and when a Fund invests in forward foreign currency contracts or uses other investments to hedge against currency risks, it will be subject to special risks, including counterparty risk.

Diversification may not protect against market risk.

Christopher Gowlland

Chris Gowlland

Vice President, Senior Quantitative Analyst

Over the past decade, Congress and the president have separately or jointly introduced policies that raised expenditures and reduced tax revenues, thus creating a long-term fiscal challenge. Despite this, investors have continued lending money to the U.S. government at relatively low interest rates, suggesting that they believed that the country would ultimately be able to bring itself back into fiscal balance. Therefore, the ongoing squabbles in Washington over the debt ceiling have not been prompted by urgent signals from the markets — they are largely a self-inflicted trauma.

When credit rating agencies are making decisions on sovereign credit ratings, they draw a conceptual distinction between economic risk and political risk. Economic risk refers to a country's capacity to make interest payments on its bonds — essentially, whether the country's economic base and demographic profile are consistent with the debt burdens that it has assumed. Political risk refers to a country's political will to ensure that such interest payments are made.

The problem facing the United States is not economic capacity. For the foreseeable future, U.S. tax revenues should be ample to cover the government's debt repayments. Relatively modest changes to marginal tax rates and mandatory programs, some of which are already projected to occur in future years, should be sufficient to bring the U.S. back into acceptable shape economically. Moreover, in spite of all the alarming and alarmist news stories on these topics in recent weeks, domestic and overseas investors generally still seem keen to buy and hold Treasury securities.

If there is no agreement to raise the debt ceiling by early August, then we may see a repeat of the winter of 1995, when there was a partial shutdown of the U.S. government. It's worth remembering that back then, there was no serious discussion of a sovereign downgrade, as everyone apparently understood that the whole exercise should be viewed largely as political theater. Late on the evening of July 31, 2011, the president and Congressional leaders from both parties and both houses announced the tentative outlines of a compromise deal that could allow the U.S. to raise the debt ceiling. If that compromise deal were to pass, then there may be no need for the government to interrupt payment on any of its obligations.

Based on the 1995 precedent, and on what is currently known of the compromise deal that has recently been proposed, it appears that the debt ceiling provision will remain in place. The U.S. is one of the few developed countries to have such a mechanism, and recent events have demonstrated that brinkmanship by an intransigent minority can be highly effective. So it's quite possible that the entire debacle could recur in future years, and there can be no certainty that the U.S. political system will be able to produce a compromise in a timely fashion on the next occasion — in which case, the government may well have to stop paying some of its bills temporarily. However, based on what is known now, it seems certain that even in the event of a partial shutdown of the government, interest payments on Treasury securities would not be affected.

A partial government shutdown could adversely affect some industries that traditionally have been viewed as defensive. For instance, it might reduce the revenues and margins of companies that rely heavily on public-sector financing, such as defense contractors and healthcare services providers. There might also be negative implications for firms that benefit directly or indirectly from government subsidies, for instance in agribusiness or housing. And if the U.S. government reduces its expenditures on Social Security, then firms that focus on older and poorer consumers might struggle — this could include some consumer staples companies that historically have been seen as stodgy but safe.

More generally, standard macroeconomic models suggest that sudden drops in public-sector spending are likely to have a negative impact on the whole U.S. economy, at least in the short run, which might cause problems for companies whose fortunes are tied closely to the U.S. market. Under such circumstances, investors might seek to raise their exposure to the rest of the world, either by investing directly in foreign issuers or by favoring U.S. firms that have extensive operations overseas. Alternatively, some investors might contemplate moving into cash — though they might also be worried about missing any rally following resolution of the current stalemate.

If an 11th-hour agreement on the debt ceiling has indeed been reached, then it's possible that a shutdown of the U.S. government may not happen. And even if a shutdown were to occur, the U.S. government apparently still has both the capacity and the intention to continue making payments on Treasurys. But the rating agencies' concerns apparently go beyond the details of the current situation. They seem to be focusing more generally on what this crisis has revealed about the capacity of the U.S. political system to cope effectively with difficult economic challenges. Thus, even if agreement is reached on the debt ceiling, the rating agencies might still consider that a sovereign downgrade is an appropriate response.

It's possible that the rating agencies might ultimately decide not to implement a sovereign downgrade, for three reasons. First, U.S. government debt is still generally viewed as the most liquid risk-free asset globally — a downgrade of the U.S. might have drastic effects on financial markets worldwide, and the rating agencies might shrink from the prospect of causing such gyrations. Second, the rating agencies themselves all have extensive operations in the U.S. and benefit considerably from their special regulatory status, so they might well be reluctant to attract official ire. And third, as noted above, there has been no indication that the government might actually contemplate ceasing to pay interest on its debt.

On balance, the near-term outlook does not look very promising. But over the medium to long term, the current difficulties will probably be seen as a blip in the overall process of recovery from the global financial crisis of 2008-2009. A few days of gazing into the abyss may well have a positive effect on some of the more intransigent political actors, ultimately putting the U.S. on a more balanced path toward fiscal probity. Investors with long investment horizons and diversified portfolios may do better by simply sitting tight.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

A Fund may be subject to some or all of the following risks. Please see the Fund's prospectus for more complete information on the risks for a particular Fund.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer's ability to make interest and principal payments on its debt.

The Funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by a Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.

High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds. The high yield secondary market is particularly susceptible to liquidity problems when institutional investors, such as mutual funds and certain other financial institutions, temporarily stop buying bonds for regulatory, financial, or other reasons. In addition, a less liquid secondary market makes it more difficult for a Fund to obtain precise valuations of the high yield securities in its portfolio.

If and when a Fund invests in forward foreign currency contracts or uses other investments to hedge against currency risks, the Fund will be subject to special risks, including counterparty risk.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

Investments in small and/or medium-sized companies typically exhibit greater risk and more volatility than larger, more established companies.

The Funds may experience portfolio turnover in excess of 100%, which could result in higher transaction costs and tax liability.

Risk controls and asset allocation models do not promise any level of performance or guarantee against loss of principal. Each Fund has a different level of risk.

Diversification may not protect against market risk.

Ned Gray

Edward A. "Ned" Gray, CFA 

Senior Vice President, Chief Investment Officer – Global and International Value Equity

From the perspective of a global equity manager, our concerns relate to the interconnectedness of capital markets worldwide. While we believe the failure of the U.S. government to meet its obligations remains a low probability, the political dimension to the process makes visibility difficult.

These concerns, coupled with the fiscal pressure and high sovereign debt levels in various markets, support our underweight position in financial stocks and our aversion to nonfinancial stocks that carry high debt levels.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

Diversification may not protect against market risk.

Ty Nutt

D. Tysen Nutt Jr.

Senior Vice President, Senior Portfolio Manager, Team Leader

The inability of Congress and the Obama administration to agree on a plan for increasing the government's borrowing limit and reducing future deficits is disconcerting. While there is a great deal of focus on the Aug. 2 deadline, the bigger concern, for us, is whether the government can formulate and implement a credible long-term deficit reduction strategy. Quite simply, the United States needs a plan that can significantly pare its long-term debt burden without derailing the fragile recovery currently under way. We believe that such a plan, which would need to include clarity on future taxation and spending policies, could reassure markets, encourage capital investment, and enhance the long-term growth prospects and global competitiveness of the U.S.

More broadly, the U.S. fiscal predicament is but one of numerous developments, here and abroad, that have caused us to take a more defensive, risk-averse positioning in our investment portfolio. This positioning has been in place for the better part of the last three years and has translated into large allocations in less-cyclical sectors such as consumer staples and healthcare that have historically had more defensive characteristics. We've also been putting a greater emphasis on quality, seeking companies that, in our view, have leading market positions, diversified business models, stronger balance sheet attributes, and sustainable dividends. We think the shares of these types of companies represent better opportunity in an uncertain macroeconomic environment and can be more resilient in a downturn.

Specific to the government's debt-ceiling issue, we view a default as unlikely. Interest payment obligations are apt to be met, although other domestic spending commitments may experience a temporary hold. A downgrade of Treasury paper seems possible, although leaders at Standard & Poor's seem to be showing a bit more flexibility in their most recent comments. The effects of a potential downgrade are hard to ascertain. A short-term dislocation in the markets (lower equity prices, higher interest rates) may be plausible, but predictions of catastrophic results (mostly from Washington) seem overblown to us. The dollar is still the world's reserve currency and, at least in the near to intermediate term, U.S. Treasury debt would still be considered among the most conservative investments. Alternatively, a breakthrough in the debt-ceiling impasse could result in a strong, though probably short-lived, market rally. While our investments may lag in such a rally, we think their upside potential, along with their more protective characteristics, could lead to competitive long-term returns.

IMPORTANT RISK CONSIDERATION

Investing involves risk, including the possible loss of principal.

Damon Andres

Damon J. Andres, CFA 

Vice President, Senior Portfolio Manager

The big question in our opinion, as we look to the remainder of 2011, is how the U.S. government plans to deal with its debt problem. The consequences of a dysfunctional government, conflicting priorities of political parties, and confirmation of troubled U.S. balance sheets will likely have a significant impact on investor sentiment.

We believe this ultimately could slow gross domestic product (GDP) growth by reducing consumer and corporate capital expenditures, weakening consumer confidence, and continuing sluggish hiring trends. Markets already seem to be estimating the risk of a downgrade in prices, though further downside volatility to debt pricing and equities appears likely. Cost of capital should increase, though perhaps only temporarily, as we believe investors will trust that the U.S. will not truly default on interest payments.

We believe that, should the U.S. default on its debts or suffer a credit downgrade, some of the worst performers would likely be consumer discretionary companies and, in the near term, those companies with higher leverage, as the risk of increasing debt costs would erode value. In such an environment, we would favor within the portfolios we manage more defensive and less leveraged companies with benign debt maturities.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors.

REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations.

A REIT fund's tax status as a regulated investment company could be jeopardized if it holds real estate directly, as a result of defaults, or receives rental income from real estate holdings.

The views expressed were current as of Aug. 2, 2011, and are subject to change at any time.

Delaware Investments, a member of Macquarie Group, refers to Delaware Management Holdings, Inc. and its subsidiaries, including the Funds' distributor, Delaware Distributors, L.P. Macquarie Group refers to Macquarie Group Limited and its subsidiaries and affiliates worldwide.

Any Macquarie Group entity or fund noted on this page is not an authorized deposit-taking institution for the purposes of the Banking Act 1959 (Commonwealth of Australia) and that entity's obligations do not represent deposits or other liabilities of Macquarie Bank Limited ABN 46 008 583 542 (MBL). MBL does not guarantee or otherwise provide assurance in respect of the obligations of that entity, unless noted otherwise. 

These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Any reproduction of these materials, in whole or in part, or the divulgence of any of the contents thereof, without prior consent of Delaware Investments is prohibited. Certain information contained herein has been obtained from sources that Delaware Investments believes to be reliable as of the date presented; however Delaware Investments cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. Delaware Investments has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. Delaware Investments and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of Delaware Investments or its affiliates.

The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or funds to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or funds for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.

Conflicts of Interest: Delaware Investments and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. Delaware Investments and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. Delaware Investments affiliates may develop and publish research that is independent of, and different than, the information contained herein. Delaware Investments personnel other than the author(s), such as sales, marketing, and trading personnel, may provide oral or written market commentary or ideas to clients of Delaware Investments or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part II of Form ADV for Delaware Management Business Trust.

Not FDIC Insured | No Bank Guarantee | May Lose Value