Here's what you should know to protect your portfolio, no matter how the politicians handle the U.S. debt debate. By Jeffrey R. Kosnett, Senior Editor July 27, 2011 Some members of Congress seem weirdly untroubled by the anxiety the debt-ceiling crisis is causing all over the planet. It gets harder every day for those of us who save and invest to watch the threat to the U.S. government's credit standing and the economy and to not get fidgety. The product of all the arguing, invective and political posturing could still end up short of a disaster. In all honesty, though, the standoff has already damaged America's financial reputation. So here are my thoughts on what’s noise that you should filter out and what you have good cause to worry about.First, don’t fret about a nuclear scenario. There is no evidence that the U.S. Treasury will deprive holders of government bonds of the interest and principal they’re due. In other words, they won’t suffer the fates of creditors of Enron or the Confederate States of America. The phrase “full faith and credit” isn’t some slogan to sell Treasury bonds. It’s a guarantee. A technical default, not an actual one, is the most likely scenario. In the event the debt limit is not increased soon enough, the Treasury would, in the most extreme case, delay making some interest payments as well as sending out some other checks. It would then catch up ASAP upon the resumption of borrowing authority. But even one day of limbo would terminate the Treasury’s stature as the world’s strongest financial institution. It would almost certainly lead to a reduction in the government’s triple-A bond rating. Treasury debt would no longer be considered ironclad and risk-free. But our triple-A rating is at risk even if the debt ceiling is raised before August 2, the date by which Treasury Secretary Timothy Geithner says the U.S. will run out of money. Wall Streeters and fund managers I’ve spoken with or listened to in the past week believe that even without a default, there’s a 50-50 chance that at least one of the three key ratings agencies (Standard & Poor’s, Moody’s Investors Service and Fitch) will cut the Treasury’s rating a notch, to high double-A, if Congress and President Obama don’t agree to a significant reduction in the nation’s spiraling budget deficit. Advertisement A downgrade would certainly harm the economy. Treasury bond yields would rise immediately, although by how much is a matter of conjecture (more on that in a bit). Mortgage rates would rise, too, because they are pegged to Treasury bond yields. That would put more hurt on housing and commercial real estate, already the causes of so much distress and unemployment. Lenders would further tighten credit because their holdings of government securities would lose value. A credit downgrade would weigh on the already creaking value of the dollar. The buck might not fall against the sick euro, but it would lose against oil, gold and other commodities priced in dollars. And while the cost of borrowing would rise, savers probably would not see any improvement in yields on bank accounts and money market funds. That’s because the Federal Reserve Board, which controls short-term interest rates, is likely on hold for as long as the U.S. economy remains sluggish and inflation shows few signs of flaring up. This brings us to stocks and bonds. Wall Street has been uncharacteristically calm even as the bickering intensifies in the capital. Investors seem to be focusing more on strong earnings reports from the likes of Apple, IBM and Ford than on the political stalemate. But the bulk of earnings-reporting season will be over by the third week of August, at which point investors can return to the dangers stemming from the impasse in Washington. Most economists believe a ratings downgrade and higher interest rates won’t automatically lead to a new recession. But if gross domestic product grows 2% annually instead of the hoped-for 3% or better for the next couple of years, the stock market becomes vulnerable. In any case, stocks are surely ripe for a correction of 10% or so between August and October. That’s common even in the best of times and isn't a justification for unloading shares unless you decide that the amount you have in stocks is too great for your risk tolerance. Advertisement Bonds are more complicated. Yes, because bond prices move inversely with yields, a rise in Treasury yields by definition means a decline in Treasury bond prices. DB Advisors, the money-management arm of Deutsche Bank, predicts that bond yields would immediately jump 0.2 to 0.3 percentage point following a default. I think that’s a conservative forecast. I could easily see bond yields rising a full percentage point over several months. That would clip the value of, say, the ten-year Treasury by about 8%. But analysts don’t expect panic selling of Treasuries. One reason is a lack of alternatives. At double-A plus, Treasuries would still be among the world’s highest-rated and most liquid fixed-income investments. Steve Johnson, chief investment officer at DB Advisors, says that, strangely enough, worried holders of long-term Treasuries would run to short-term Treasuries -- say, those maturing in six months up to two years. The buying would further drive down their yields, which are already minute. Like stocks, municipal and corporate bonds have also remained mostly above the fray. The prognosis for these categories is favorable. Many advisers are enamored with munis, partly because their yields are high compared with Treasuries and partly because, notwithstanding scaremongering by the likes of analyst Meredith Whitney, most state and local issuers are in decent financial shape. So there’s no reason to unload high-quality munis or funds that invest in them. The main concern is that if Uncle Sam is downgraded, the ratings agencies may nick the ratings of states, such as Maryland and Virginia, that are closely tied to the military and government workers. But those states are among the strongest ones, and a drop from triple-A to double-A won’t matter if you’re angling for good after-tax income. High-grade corporate bonds are also unlikely to suffer. For the most part, corporate America is in great financial shape, having fattened its balance sheets since the last recession ended in 2009. If anything, companies are being even more conservative with their cash as they get ready for chaos in the credit markets in the event of a government default. The few remaining triple-A-rated U.S. companies -- Automatic Data Processing, ExxonMobil, Johnson & Johnson and Microsoft -- will benefit from their scarcity. The same is true of double-A-rated corporate debt. Balance sheets are strong, and profits are high. If you want to switch some money from a fund that owns medium-term or long-term Treasury bonds to one that owns higher-quality corporates, go for it. Advertisement But get ready for more volatility in junk bonds and possibly in corporate debt rated triple-B (the lowest investment-grade rating). One reason is that many pension funds and other institutions are required by their bylaws or their clients to keep an overall portfolio average rating of at least double-A. If Treasuries are downgraded to that level, these investors will need to avoid or trim their holdings in lower-rated bonds to offset the government’s downgrade. Besides, junk is already expensive relative to Treasuries. Funds that invest in junk bonds could easily experience double-digit losses, particularly if the economy returns to recession. Foreign bonds can offer good income and can serve as a hedge against a falling dollar. Only a few big nations are still rated triple-A -- Canada, Germany and Australia among them -- but smart bond fund managers skip debt from basket cases, such as Greece and Portugal, that might default involuntarily. Funds that own foreign bonds are enjoying solid returns in 2011; the average emerging-markets bond fund was up 6.1% year-to-date through July 26, and the average global bond fund was up 5.4%. Those kinds of funds may not continue to appreciate at the same rate, but expect them to deliver decent results regardless of what does or doesn’t happen in Washington in the days and weeks ahead.