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After the Vote: Your Investing Guide to the Federal Debt Deal

The politicians raised the debt ceiling just in time, but investors may still be struggling with their portfolios. Here’s our advice.

Editor's Note: This story has been updated since its original publication on August 2, 2011. Previously, on July 27, Jeffrey Kosnett wrote CASH IN HAND: Your Investing Guide to the Debt Ceiling Crisis, warning that “stocks are surely ripe for a correction of 10% or so.” Since then through August 4, the Dow has fallen 1,118 points, or 8.9%.)

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So much for enactment of a debt-ceiling hike smoothing the feathers of ruffled investors. The markets are acting as if the threat of imminent default by the U.S. Treasury were still real. The Dow Jones industrial average, which fell a little on August 1, the day after House Republicans and President Obama struck their deal, plunged 266 points, or 2.2%, on August 2. The selloff accelerated after the Senate passed the bill and sent it to Obama for his signature. On August 4, the Dow tumbled another 513 points, or 4.3%. Meanwhile, gold set another record, climbing as high as 3.9% between August 1 and August 4, to $1,683 an ounce. And investors continued to pour money into the ostensibly safe haven of Treasury bonds, pushing their prices up and their yields down. The ten-year Treasury now yields 2.46%, its lowest level since last November.

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The reason for this unholy market trinity: Now that Washington’s version of the theater of the absurd is in intermission, investors are focusing on the real economy, and they don’t like what they see. Not even a raft of solid second-quarter earnings reports can cut through the gloom. (See SLIDE SHOW: Earnings Reports That Matter Most.) With more than 60% of the companies in Standard & Poor’s 500-stock index having reported results, second-quarter earnings are up 10.3% from the same period in 2010, says Thomson Reuters. Take away results for Bank of America (symbol BAC), which lost $20.7 billion, primarily because of write-offs on bad mortgages, and profits for the S&P 500 are up a nifty 16.3%, says Thomson.

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Reacting to stunningly positive earnings reports from the likes of Apple (AAPL) and International Business Machines (IBM), stocks surged in early July. But since the third week of July, earnings reports and accompanying comments from corporate officials have had a much more cautionary feel. The Dow, which had made a run toward 13,000, started its sag on July 22, when Doug Oberhelman, CEO of Caterpillar (CAT), leavened a decent earnings report with such red-flag phrases as “softness in China” and “a lack of confidence in the business climate” in the U.S. Never mind that CEOs say such things all the time on calls with analysts. Cat’s growl was supremely untimely for the stock market, which was just starting to get fidgety about the bond-default and credit-downgrade matters. Since that day, stock prices have ratcheted down daily and are 6.7% off their July peak.

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And key economic statistics aren’t doing much to instill confidence. The latest report on consumer spending, released August 2, showed a decrease of 0.2% in June, the biggest decline since September 2009. And data released August 1 by the Institute for Supply Management indicated a slowdown in the nation’s factories. Both of these figures suggest that corporate America will have a hard time delivering stellar earnings numbers in the third and fourth quarters of 2011. And, although scattered companies such as General Motors (GM) and Disney (DIS) could drive the market to an occasional winning day, the current downturn is beginning to look like a genuine correction (a decline of at least 10%) -- the first one since the bear market ended in March 2009. For stocks to break out of their funk, you’ll need to see better news on jobs, industrial output, exports, retail sales and gross domestic product. Few economists and fewer stock-market strategists foresee much of that in the months ahead.

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The outlook for bonds is more complicated. A downgrade of the U.S.’s bond rating by one or more of the credit-rating agencies remains a distinct possibility. The issue is no longer the debt ceiling but the inability of our political system to reign in soaring budget deficits. The next round of budget negotiations -- to be conducted by 12 members of Congress who will be tasked with finding and agreeing on more budget cuts, tax increases or a combination of both -- will play a major role in determining whether U.S. bonds remain triple-A or slip to the high double-A level.

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If the agencies do downgrade Treasury debt, panic selling of bonds isn’t likely to ensue. The fact is, there aren't many alternatives that are as safe and liquid as Treasuries. Treasury debt accounts for 55% of the worldwide supply of triple-A debt securities -- that includes the IOUs of all foreign governments, plus corporate and municipal obligations. At a rating of double-A-plus, Treasuries would still be among the world’s highest-rated and most-liquid investments.

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Interest rates on Treasury bonds would edge up -- a good guess is about a quarter of a percentage point at first. If you own a mutual fund or exchange-traded fund that owns Treasuries, that would knock 2% to 3% off its value. But yields wouldn’t climb enough to make Treasuries particularly appealing for income investors.

Fortunately, other investments can provide decent income without much risk. Municipal and corporate bonds held their value through the debt fight, and as long as the economy doesn’t fall into a fresh recession, the principal and interest are secure. Many advisers are recommending munis, partly because their yields are high compared with Treasuries. However, you (or your fund manager) need to pick bonds carefully. Cuts in federal aid to states will hurt such issuers as hospitals, nursing homes and colleges. Stick with general-obligation bonds or bonds secured by essential services such as water, roads and sanitation services. Munis rated single-A or higher are fine; even issuers rated triple-B, the lowest investment-grade ranking, rarely default.

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The same is true with high-grade corporate bonds. Only four U.S. companies carry triple-A ratings, but, with profits still high and balance sheets strong, you should be okay with anything down to single-A. If you want to switch from a Treasury fund to a corporate bond fund or go-anywhere bond fund, such as Loomis Sayles Bond (LSBRX), go for it.

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 and high-dividend foreign stocks remain an ideal diversifier for income and safety. Combining an emerging-markets bond fund with an international bond fund is a smart strategy. For dividends from abroad, consider an ETF such as iShares Dow Jones International Select Dividend Index (IDV). It yields nearly 5%.

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