Washington is at an impasse on the debt ceiling. Here’s what that might mean for your portfolio

Published Thu, May 11 20233:00 PM EDTUpdated Thu, May 11 20235:39 PM EDT

Income-focused investors seeking yield and safety in Treasury bills are likely nervous as debt ceiling rhetoric heats up in Washington, but they should take a breather before they dump these assets. Talks between President Joe Biden and congressional leaders are expected to continue next week — postponed from Friday — as officials work toward overcoming their standstill on the debt ceiling. On Tuesday , Biden met with House Speaker Kevin McCarthy, R-Calif., and Minority Leader Hakeem Jeffries, D-N.Y., as well as Senate leaders. Officials are scrambling to hammer out a deal as the so-called X-date, the day when the U.S. government may be unable to pay all its bills on time, approaches. Treasury Secretary Janet Yellen has said that day could come as early as June 1 . In the short-term Treasury market, investors are already showing some signs of anxiety. The yield on the 1-month T-bill has surged since the beginning of May, when Yellen warned of the rapidly approaching X-date. On Thursday, the 1-month T-bill yielded 5.5%, while the rate on the 3-month bill was 5.2%. "Short-term yields for T-bills maturing in this window of uncertainty are elevated versus longer term because it's pricing in some risk — some very small risk — there would be a technical default, which means delayed interest and principal payments," said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. Tensions could rise for investors the longer officials go without a resolution, particularly if that standstill goes beyond the June 1 X-date. "Moody's doesn't need to declare a default for investors to treat it like a default," said Gustavo Schwenkler, associate professor of finance at the Santa Clara University Leavey School of Business. In that case, holders of short-term T-bills could see declines in their portfolio values as yields spike, he added. Bond prices move inversely to yields, meaning prices weaken as yields advance. Review your holdings Now could be a good time to review your bond holdings, particularly the short-term T-bills that are seeing a big jump in yields. Investors most worried about 1-month T-bills may want to roll into some six-month and 1-year issues to manage volatility, Jones said. But the longer-term advice is to snap up longer-dated bonds to prepare for the day the Federal Reserve starts to dial back its tight monetary policy. "The guidance has been for a while to extend duration," Jones said, adding she understands why investors might be more inclined to pursue 5% yields in certificates of deposit and short-term T-bills. "Historically, once the Fed is past the peak in tightening, which we think is likely, intermediate-term bonds — that 5- to 7-year maturity bucket — tend to outperform on a total return basis." She noted investors could face reinvestment risk if they load up on short-dated Treasury bills and notes that aren't locking in some of today's higher yields. Thomas McLoughlin, head of fixed income and municipal securities at UBS, recently said for investors who use a barbell strategy, that is, they hold a portfolio of short- and long-term bonds, "a modest pivot toward longer-dated bonds would be appropriate." Yields on these longer-dated instruments are likely to decline — and prices will likely rise — as portfolio managers reposition in anticipation of the Fed eventually softening its policy, he wrote. Longer-dated, tax-exempt municipal bonds could also outperform corporate bonds, McLoughlin added. "Munis are more insulated from the market volatility that imperils the total return available on corporate bonds," he said. A well-timed gut check For investors who have sought to spread interest rate risk by building a ladder of Treasurys — that is, holding issues with both shorter and longer maturities — it's worth remembering what works in a recessionary environment. "High-quality bonds, especially government bonds, have been reliable in an economic downturn," said Christine Benz, director of personal finance at Morningstar. "When you think about your portfolio, you're trying to ward against a lot of different risks. You don't want your portfolio to thrive in just one scenario like a default." However, if you're losing sleep over short-term triggers, such as Washington's fight over the debt ceiling and the looming 2024 election, it might be time to make sure your portfolio truly reflects your risk appetite. "I wouldn't readjust my whole strategy because [the debt ceiling] is likely going to get resolved," said Jamie Hopkins, managing partner of wealth solutions at the Carson Group. "If you are panicking, it probably means your asset allocation isn't the correct one for where you are in your life right now," he added. — CNBC's Michael Bloom contributed to this report.