How to play it - A debt ceiling sequel?

NEW YORK Thu May 24, 2012 10:44am EDT

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NEW YORK (Reuters) - Another showdown between Republicans in Congress and President Barack Obama over debt could be in the making, and some investors are already taking steps to prepare for it.

While most of the market was focused on Europe's debt crisis and Facebook's stock debut last week, Republican House of Representatives Speaker John Boehner said he would back another increase in the federal government's debt ceiling only if it were offset by a larger package of spending cuts.

Chris Van Hollen, the top Democrat on the House Budget Committee, quickly denounced the proposal.

While some element of election-year political theater may be at play, some money managers are preparing for a repeat of last summer's debt debate, which sent the Standard & Poor's 500 Index plummeting about 17 percent through August 22 from its monthly high on July 7.

"We're certainly thinking about it now, and if the market isn't thinking about it yet, it certainly will be soon," said Ann Miletti, a senior portfolio manager for Wells Fargo Advantage Funds who manages approximately $3.2 billion in assets.

The debate this year comes with an additional wrinkle. As part of the compromise last year to raise the debt ceiling, Congress passed a bill that would cut government spending and let Bush-era tax cuts expire at the end of 2012, which would revert taxes on dividends back to ordinary income levels and capital gains back to 20 percent.

While the plan would reduce the federal budget deficit by $607 billion, it also would force the economy into a recession in the first half of 2013, according to the non-partisan Congressional Budget Office. The result would be a jump in unemployment and lower tax revenues, the CBO said.

PREPPING BOND PORTFOLIOS

Some money managers are positioning their portfolios for a volatile end to the year.

Wilmer Stith, portfolio manager of the $300 million Wilmington Broad Market Bond fund, is following the same strategy that he turned to in the run-up to the debt ceiling standoff last summer.

"Unfortunately, the confidence that businesses need the most is hamstrung by politics, and as a result we're becoming more defensive than we would be otherwise," he said.

Stith has been reducing his positions in lower-rated, more volatile corporate bonds in expectation that negotiations in Washington will again go down to the deadline.

He's buying investment-grade corporate bonds issued by companies like Microsoft, Google and ConocoPhillips that are highly liquid and have average maturities of about five years. These securities are more attractive than comparable U.S. Treasury bonds, he said, which have recently offered historically low yields.

"You are taking some corporate risk, but I think that these offer investors a better relative value," he said.

Mike McGervey, president of McGervey Wealth Management in North Canton, Ohio, said he has been reducing his holdings of growth stocks and adding mortgage notes with an average of five years to maturity. Despite his concern about the government debate, he's shunning short-term bonds and instead focusing on highly rated intermediate municipal and corporate bonds, finding support for his position in the policy stance of the U.S. Federal Reserve.

"The (Fed) has been very open in saying that it will be accommodative in terms of monetary policy, which to me is a green light that it's okay to go further out on the yield curve," he said.

McGervey is largely staying away from longer-term government bonds, citing the current, very low yields. "I think the 10-year Treasury is nearly as low as it can go. If it went any lower the global economy as a whole would not be in good shape and we'd have even bigger problems," he said.

Investors who prefer exchange-traded funds have a few options to follow the same strategy. The $149 million PIMCO Intermediate Muni Bond Strategy, for example, focuses mostly on education and state and local general obligation bonds. It costs 35 cents per $100 invested and yields 2.2 percent.

Investors in taxable accounts, meanwhile, could consider the $2.2 billion Vanguard Intermediate Term Corporate Bond Index. All of its portfolio is rated BBB or higher, according to Morningstar, with 56 percent of its holdings rated A or above. Top holdings include issues from JPMorgan Chase, AT&T and Pfizer. The fund charges 14 cents per $100 invested and yields 3.6 percent.

PLANNING FOR STOCK VOLATILITY

Equity investors are also planning for a volatile end to the year.

Alan Gayle, senior investment strategist at RidgeWorth Investments, is pessimistic that Washington will reach a compromise before the so-called "fiscal cliff" of spending cuts and higher taxes takes effect at the beginning of January.

"Given Congress and the president's track record, it seems like they are only able to take action when they are up to the 11th hour," he said.

Gayle is focusing on companies that are able to increase revenues in a slowly growing economy, increasing his position in the technology and health-care sectors.

"The prospects for healthcare have improved, particularly if we see more of these risk on/risk off days, because there are attractive valuations," he said. Gayle is shying away from traditional defensive plays like telecom, utilities and consumer staples because, he said, their valuations offer "little upside potential."

Pharmaceutical stocks, in particular, have lagged the broad S&P 500 index since the sweeping U.S. healthcare reform passed in 2010. More than $70 billion of revenue from branded drugs will be lost as a result of patents expiring through the end of 2015, according to ratings agency Fitch. Gayle, however, said the sector's high dividends and growth potential makes its attractive.

The $800 million Vanguard Health Care ETF is one popular option for investors, according to Morningstar. The fund, which charges 19 cents per $100 invested, has about 25 percent of its assets invested in Johnson & Johnson, Pfizer Inc and Merck & Co, according to Morningstar. It yields 1.6 percent and is up just 0.1 percent since the start of the year.

Miletti, of Wells Fargo, said that no matter what the outcome in Washington, "2013 won't be a great growth year."

In the $1.2 billion Wells Fargo Advantage Common Stock fund, Miletti is turning to small- and mid-cap companies that she believes trade at significant discounts to their private market valuations, giving them both high cash flows and making them attractive as potential takeover targets.

Her top three holdings are Grand Canyon Education, CapitalSource Inc and Wabash National, according to Morningstar.

(Editing by Walden Siew and Leslie Adler)

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