Debt-ceiling countdown: We answer your FAQs

Fidelity Viewpoints 07/27/11

Six Fidelity experts weigh in on the outlook and potential implications for investors.

Will Democrats and Republicans find common ground on a deficit reduction plan in time to extend the U.S debt ceilingand avoid a potential U.S. government default? No one can say for sure, but Fidelity experts strongly believe Congress will ultimately act to avert a default. The questions: when, how, and what it will mean to investors worldwide. "The key to weathering these risks is preparation," says Fidelity portfolio manager Joanna Bewick, who manages Fidelity Strategic Income Fund (FSICX), Fidelity Strategic Dividend & Income Fund (FSDIX), and Fidelity Strategic Real Return Fund (FSRRX). And that goes for individual investors as well as fund managers. "Investors must have a sound investing plan that focuses on building a well-diversified portfolio that balances their unique time horizon, risk tolerance, capital appreciation, and income needs across a variety of market environments," says Bewick. "Indeed, a rigorous investment plan is timeless and transcends current events." Here six Fidelity experts, including Fidelity fund managers and political veterans, answer some of your most frequently asked questions about the implications of the debt-ceiling debate.

What do we need to know about the debt-ceiling situation? What does the August 2 deadline really mean? How might lawmakers and the president resolve this situation? What happens if August 2 arrives without an agreement in Washington? How might this issue impact investments in stocks and stock mutual funds? How might this issue impact investments in bonds and bond mutual funds? How might this issue impact investments in money markets and money market funds? What should I do with my investment portfolio as the deadline approaches if no agreement is yet in place? How is Fidelity preparing for a scenario in which no agreement is reached to raise the debt ceiling in advance of the August 2 deadline?

What do we need to know about the debt-ceiling situation?

Dirk Hofschire, CFA, vice president, Fidelity Asset Allocation Research
"The debt ceiling is essentially a self-imposed, near-term deadline on a very serious medium-term fiscal problem. In this respect, the debt-ceiling situation is something of an artificial, or self-made, crisis. Congress passed a law that limits how much the U.S. can borrow, but it can pass another one raising that amount (as it has several times before). The near-term concern among investors in the global financial markets is not about Americas ability to service its debtit is about its willingness to do so. The good news about the artificial or self-made nature of this situation is that it can be quickly remedied if policymakers decide to willingly continue servicing the debt. If you contrast this with Greece, for instance, the problem for the U.S. is much more manageable. Currently, yields on two-year Greek government bonds are around 25%, reflecting that investors are concerned that Greek debt levels are unsustainable and need to be restructured. With rates this high, Greece is effectively locked out of the markets, unable to roll over its debt. The U.S. government, in contrast, can issue 10-year bonds at just 3%, implying the U.S. is having no trouble financing its near-term obligationsas long as it chooses to continue to do so. The unfortunate part of the situation is that there may be some risk to financial markets if a final resolution is delayed due to the polarized debate in Washington. Uncertainty creates volatility, which translates into larger price fluctuations in the financial markets. As we approach the August 2 deadline without a legislative agreement, I believe volatility will continue to increase. However, once there is a resolution of the situation and the debt ceiling is raised, the markets are likely to reverse course and benefit from a relief rally. In my view, the more acute the sell off and volatility leading up to the deadline, the more likely policymakers will feel urgency to resolve the issue, making a market reversal even more likely. This potential volatility makes it very difficult as an investor to take any action, which means one should tread carefully before trying to make tactical decisions based solely on the near-term outlook for the debt-ceiling situation. No matter what happens in the near term, it is unlikely that any policy action that comes together in the context of a debt-ceiling agreement will in and of itself solve all the medium-term challenges to the U.S. fiscal outlook. The government will still have plenty of work to do over the next couple of years to put the budget trajectory on a more sustainable path, and the importance of getting this right will be a major factor affecting how well the economy and financial markets perform over the next several years."

What does the August 2 deadline really mean?

Karthik Ramanathan, senior vice president/director of bonds, Fidelity Management & Research Co.
"Tuesday, August 2 is essentially a 'line in the sand' for reaching an agreement on raising the debt ceiling. While an actual agreement may come earlier or later, this is the date when the U.S. Treasury has said it would run out of extraordinary tools to stay under that ceiling. By law, once the debt ceiling is reached, the U.S. Treasury cannot borrow additional money to meet its expenditures. Specifically, the Treasury has publically stated several times that beyond that date, the United States will not be able to borrow to continue making interest and principal payments on its debt in addition to continue meeting payments for other government expenses. In my view, such a situation would cause the credit rating agencies to downgrade U.S. government debt 1 from its AAA status. More concerning, however, is that if agreement to raise the debt ceiling is not ultimately reached, it could lead to a technical default for the country."

How might lawmakers and the president resolve this situation?

Shahira Knight, vice president, Fidelity Government Relations
"The Administration has asked for a $2.4 trillion increase in the debt limit, which would extend Treasury's borrowing authority through the end of next year. The bipartisan leadership of the House and Senate agree that the debt ceiling must be raised and default is not an option. However, many members of Congress will not vote to increase Treasury's borrowing authority unless significant deficit reduction measures are adopted. The Republican leadership has set a marker that any increase in the debt ceiling must be accompanied by at least an equivalent amount of spending cuts. The President had hoped for a "grand deal" that would combine a debt limit increase with $3 trillion $4 trillion of deficit reduction measures, including savings from entitlement programs and tax reform. However, negotiations on a grand bargain stalled when both sides could not reconcile fundamental differences over the framework for a comprehensive approach. In the absence of a grand bargain, the House and Senate have put forward different plans. The House passed a bill championed by conservatives that would cap federal spending and increase the debt limit increase only after a constitutional balanced budget amendment is sent to the states for ratification. However, the Senate voted to block this bill from advancing. In the meantime, the top Republican and Democrat in the Senate developed their own proposal that would allow the debt ceiling to be raised in three installments. Each installment could be disapproved by Congress, but the President could veto the disapproval. This proposal is considered an option of last resort, and there are no immediate plans for its consideration. After further negotiations failed to produce an agreement, House Speaker John Boehner (R-OH) and Majority Leader Harry Reid (D-NV) introduced different bills. Both bills seek to cut discretionary spending by $1.2 trillion over 10 years, and both create a new Joint Committee of Congress tasked with reporting legislation in the coming months that would achieve additional budget savings. Neither plan raises taxes, and neither plan makes cuts to Social Security or Medicare. The most significant difference between the two plans is that the House proposal would increase the debt limit by $2.5 trillion in two stepsan immediate increase of almost $1 trillion and an additional increase of $1.6 trillion early next year if the Joint Committees legislation is enacted). In contrast, the Senate proposal would immediately increase the debt limit by $2.4 trillion while relying on $1 trillion of additional spending cuts from the wind down of military operations in Afghanistan and Iraq. The House and Senate are expected to take up their respective bills later this week. However, the fate of both bills is uncertain. Senate Democrats oppose the two-step approach in the House bill because it does not extend Treasurys borrowing authority through the end of next year as the Administration requested. The Administration issued a statement indicating that senior aides would recommend a veto of the House bill if it is presented to the President in its current form. Similarly, House Republicans say the Senate bill relies on accounting gimmicks because the $1 trillion of defense cuts are already scheduled to occur (since the Pentagons budget already assumes a draw down of troops). It is unclear how these differing approaches will be reconciled over the coming week, and the situation remains fluid."

What happens if August 2 arrives without an agreement in Washington?

Karthik Ramanathan, senior vice president/director of bonds, Fidelity Management & Research Co.
In the past, Congress has always voted to raise the debt ceiling, even in small increments, to ensure that the U.S. continues to meet its fiscal obligations. In my view, policymakers recognize the risks of failure, and therefore will ultimately increase the debt limit, though probably not until the last minute. However, if Tuesday, August 2, arrives with no agreement on raising the debt ceiling, several potential outcomes could result.

First, most investorsparticularly international investorscould realize that what simply appears to be political theatrics in Washington, D.C., has become a much more serious issue. This could manifest into concern about Congresss ability and willingness to reach any deal in a timely manner. Moreover, many investors still may not understand the difference between a debt-ceiling increase and a default. Such uncertainty is likely to unsettle equity and bond markets around the world until Congress does eventually reach some type of agreement. Second, the U.S. Treasury is likely to postpone or potentially reduce the size of Treasury auctions scheduled for the coming week to remain below the debt ceiling. The shuffling of auction dates would add further uncertainty to financial market participants, and possibly lead to higher borrowing rates for the government. Third, if the debt ceiling is not raised by August 2, the U.S. Treasury likely will need to operate on a cash-flow basis. This means Treasury will determine which payments to make and which to defer based on daily incoming tax receipts until an agreement to raise the debt ceiling is reached. In my view, Treasury is likely first to use any incoming tax revenues to make upcoming interest and principal payments to ensure that investors in Treasury securities are fully paid. Any remaining funds after meeting these interest and principal payments would be used for other obligations of the government such as Social Security and Medicare and Medicaid payments. At the same time, the Treasury would conduct Treasury auctions to replace exactly those Treasuries maturing, therefore not adding any additional debt to the balance sheet.

How might this issue impact investments in stocks and stock funds?
Dirk Hofschire, CFA, vice president, Fidelity Asset Allocation Research
If market volatility continues to rise due to nervousness of the approaching debt-ceiling deadline, I believe riskier asset categories such as stocks would likely see the widest fluctuations in prices for two main reasons. First, when uncertainty grows in advance of a potentially market-moving event, investors tend to gravitate toward less risky securities such as cash. As the traditionally most volatile asset class, stocks are perceived as the most vulnerable to large price fluctuations during a general investor flight to quality. Second, the impact of not raising the debt ceiling would be tremendously negative for the U.S. economy. The U.S. runs a budget deficit equal to roughly 9% of GDP, implying that the economy is currently receiving a massive boost from government spending that is not financed by tax revenues. If the U.S. were to stop its net borrowing overnight, the U.S. would in effect have to cut that 9% of GDP of government spending down to zero, which would be a massively austere fiscal adjustment that most likely would plunge the U.S. economy into recession over time. In my view, that would be negative news for stock prices because it would translate into rapid deterioration in corporate profits.

How might these issues impact investments in bonds and bond funds?
Franco Castiagliuolo, co-portfolio manager of Fidelity Government Income Fund
If the debt-ceiling debate is not resolved in time, the rating agencies will likely downgrade the U.S. rating, which could cause market disruptions that include sending Treasury bond yields higher. A downgrade could create market disruptions for other fixed income issuers as well. Treasuries are used as a benchmark for a large portion of the fixed income market; thus, an increase in the yields of Treasury securities could be transmitted to others, creating higher borrowing costs across the fixed income markets. In addition, issuers that are viewed as being supported in some way by the United States, such as GSEs (government sponsored enterprises), could also see their borrowing costs rise. However, a major disruption is likely to bring about renewed efforts in Washington to find a solution. As a result, market dislocations associated with potential default may be short lived in nature. But eventual solution on the debt ceiling may not end the focus on the U.S. fiscal situation. Both rating agencies and the markets are now focused on Congress delivering a credible long-term plan to reduce the deficit.

How might this issue impact investments in money markets and money market funds?
Tim Huyck, portfolio manager for Fidelity's money market portfolios
"Fidelity believes that the government will ultimately increase the debt ceiling. Nonetheless, we have been preparing contingency plans that relate to how our money market mutual funds are positioned, as well as to our overall operations. I believe Fidelitys money market funds, including our Treasury money market funds, are appropriately positioned for a potential severe disruption in the markets. We have stress tested our money market mutual funds, and we believe they can withstand significant market volatilityfar more than the historical largest one-day move in three-month bills that occurred in the last 40 years. If the United States were to be downgraded to AA from its current AAA rating, money market mutual funds would not be forced to sell their government securities. Indeed, the funds could continue to purchase U.S. government securities, provided that the securities were determined to represent minimal credit risk. Overall, we believe money market mutual funds are more resilient than ever before. Since the changes to money market regulations were implemented over a year ago, these funds have greater liquidity, frequently far in excess of the 10% daily and 30% weekly liquidity requirements, and also maintain shorter weighted average maturities. Money market funds are also much more transparent, prominently disclosing holdings on a monthly basis."

What should I do with my investment portfolio as the deadline approaches and no agreement is yet in place?
Joanna Bewick, CFA, portfolio manager Fidelity Strategic Income Fund, Fidelity Strategic Dividend & Income Fund, and Fidelity Strategic Real Return Fund
"It is understandable that investors are anxious about policymakers ability to reach agreement on the debt ceiling. While the debt-ceiling debate may pose a unique risk, its important to remember that event risk is endemic to the capital markets. The key to weathering these risks is preparation. Investors must have a sound investing plan that focuses on building a well-diversified portfolio that balances their unique time horizon, risk tolerance, capital appreciation, and income needs across a variety of market environments. Indeed, a rigorous investment plan is timeless and transcends current events. Take a long-term view and continue on a steady investment course, but revisit your investment objectives on a periodic basis to ensure that the plan is current and reflective of your long-term goals. Moreover, near-term volatility may present an opportunity to rebalance if market moves cause your portfolio to stray from your asset allocation targets. Now, more than ever, investors must not let the uncertainty of short term events cause them to make rash portfolio decisions. Trying to time market gyrations is difficult and often costly. History has shown that near-term market declines, although unnerving at the time, are often followed by rebounds. In many cases, investors are better served by remaining fully invested over a market cycle, enduring near-term volatility but not missing out on the subsequent recovery. Give your investment plan time to work for you over the entire market cycle."

How is Fidelity preparing for a scenario in which no agreement is reached to raise the debt ceiling in advance of the August 2 deadline?
Fidelity is actively monitoring the ongoing debt ceiling and budget debates, because measures taken or not takenmay have ramifications for the broader market, and therefore for our customers and

shareholders. Internally, Fidelity is utilizing existing response and contingency plans as well as event management protocols to assess and mitigate investment, operational, and counterparty risks across our complex. Probable scenarios have been developed and exercised to ensure that, as an organization, we have a robust response plan that encompasses multiple scenarios to support our customers and shareholders.

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Past performance is no guarantee of future results. 1 An AAA credit rating that can be given to a share, bond, or bank by U.S. credit rating agencies such as Standard & Poor's or Moody's indicates that it is considered to be a very safe investment. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund. Neither asset allocation nor diversification ensures a profit or guarantees against loss. Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longerterm securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. The information presented above reflects the opinions of speakers as of the July 26. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund. Investment and workplace savings plan products and services offered directly to investors and plan sponsors are provided by Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917. Investment and workplace savings plan products and services distributed through investment professionals provided by Fidelity Investments Institutional Services Company, Inc., 100 Salem Street, Smithfield, RI 02917. 588999.6