By Steven C. Johnson and Jennifer Ablan
NEW YORK (Reuters) - Investors who behave conventionally are likely to get burned if the political standoff over the federal budget and the debt ceiling ends up forcing the United States to default.
But portfolio managers and strategists say that if investors put their trading hats on, they may be able to protect themselves and even possibly come out ahead.
"The next two weeks could cause a lot of pain in many portfolios," said Mark Yusko, CEO and chief investment officer at Morgan Creek Capital Management, LLC, in New York.
One of the few things pros like Yusko agree on when it comes to the partial U.S. government shutdown that began this week and the possible failure to raise the government's legal borrowing limit by October 17 is that market turbulence is likely to rise.
U.S. stocks retreated for a second straight day on Thursday as the shutdown dragged on and the dollar weakened broadly. While the selling has been orderly so far, investors see anxiety rising if the weekend arrives without any sign of a political deal.
One way to take advantage of that, portfolio managers say, is to simply bet on more volatile trading rather than try to navigate the ups and downs of the stock or bond markets.
The CBOE Volatility Index <.VIX>, the world's best-known fear gauge, hovered around 17 on Thursday, roughly a two-month high but still a far cry from 48, where it peaked in 2011, the last time Congress threatened not to raise the debt ceiling.
"Even a legitimate threat of a default will send volatility exploding - even to the 30s," Yusko said. "You can make a lot of money in a short period of time."
Yusko said investors can get exposure via the unleveraged iPath S&P 500 VIX
For those who think it could approach 2011 levels again, snapping up a buy option now looks like a bargain and could be a nice way to hedge against losses elsewhere.
The same goes for buying options to sell the S&P 500 index, said Dan Greenhaus, chief global strategist at BTIG.
"The environments are certainly different, but given the similarities on the legislative side of things, we wonder why volatility hasn't already begun moving higher," he said.
Douglas Peebles, chief investment officer for fixed income at Alliance Bernstein, added: "Don't short volatility. Because all roads lead to it. There is going to be less liquidity and more question marks about gridlock and growth. That's painful to sit through, but it's fertile ground" for increasing returns.
For longer-term mom-and-pop investors whose exposure to markets is concentrated in their 401ks, increasing cash holdings could offer some protection, particularly for older savers heavily invested in typical stock and bond funds.
SITTING ON CASH
Dan Yu, managing director of EisnerAmper Wealth Advisors LLC, said his clients' portfolios are sitting on cash of between 10 to 12 percent, up from 2 to 3 percent in July. "We're cash-heavy but I might be a buyer if we see a 5 percent pullback in the stock market," Yu said.
After the 2011 debt ceiling fight ended with Standard & Poor's stripping the United States of its AAA credit rating, the benchmark S&P 500 index had one of the most volatile years in the market's history, logging the first zero percent performance in decades.
But as the credit crunch in 2008 taught investors, even cash isn't safe when panic and forced selling ensue.
That's because many money market funds invest in short-term cash equivalents such as T-bills, which in this case could be most at risk if the U.S. government goes into technical default.
Reserve Money Market Fund shares fell below $1 in 2008 when it was forced to write off debt issued by Lehman Brothers, whose failure marked the depth of the global financial crisis.
Investors have been avoiding Treasury bills that come due in mid-to-late October and early November, which have the highest risk of a default.
That has pushed one-month Treasury bill yields above those offered on longer-dated Treasuries. One-month yields rose to 0.13 percent on Thursday, the highest since November, and well above the 0.02 percent three-month yield.
Most investors expect longer-dated U.S. Treasuries to hold up fairly well in the leadup to the debt ceiling showdown, and perhaps to rally even in the event of a default. That's what happened in 2011 when the U.S. credit rating was downgraded.
That is partly because few markets offer the size and liquidity of the U.S. government bond market. And it is partly because few expect a default to last long.
"Missing a single payment or a series of social security payments is incredibly damaging, of course, but that's still very different from Argentina informing the world, as it did a few years ago, that it's defaulting on its debt," said Andrew Milligan, head of global strategy at Standard Life Investments.
"What it does, though, is that it slowly undermines the status of the U.S. dollar. If there was a period of time, even a day, when someone can't transact what he wanted to transact, that memory will last a long time. That's when you start to see people trying to make sure that they are diversified," he said.
Beneficiaries are likely to be government debt from advanced economies such as Japan, Germany, Switzerland and the UK.
Analysts at Societe Generale have advised clients that a U.S. debt default was improbable, but a rise in market fears that such a catastrophe could happen would in itself be a risk to hedge against.
Societe Generale analyst Eamon Aghdasi recommends investors buy volatility through options or other structures in the Brazilian real or Mexican peso.
Another hedge would be through Chile's rates markets, involving receiving swaps to protect against stress in debt markets, Aghdasi said in a note to clients.
Dan Fuss, who helps manage $190 billion in assets as vice chairman of Loomis Sayles, said he is hanging onto his longer-dated U.S. Treasuries.
Nonetheless, he's spent the past few days inundated with calls and emails from clients, particularly those from outside the United States.
"There's a very real concern about the U.S. and its weakening position in the world," he said.
(Additional reporting by Sujata Rao-Coverley in London and Vidya Ranganathan in Singapore.; Editing by Christopher Wilson)