Editor’s Note: The US Congress and President Obama have yet to strike a deal over whether to raise the US debt ceiling. Global markets hang in limbo as a default grows more possible with each passing day. This week, we’re reprinting a conversation I recently had with Corey Amon, director of research at Taplin, Canida & Habacht about the potential consequences of a US default. We interviewed Amon on the day that Standard & Poor’s downgraded its outlook for US government debt. Three months later, Amon’s analysis remains spot on and his predictions seem almost prescient.

Standard & Poor’s (S&P) today downgraded its outlook for US government debt. Should investors be concerned?

There’s certainly some downside risk to prices, particularly in this exceptionally low interest rate environment. The unconventional tools that the Federal Reserve has used have resulted in artificially low Treasury yields. But economic fundamentals will lead to rising interest rates, which are driven by expectations for inflation. This problem will become particularly acute as the Fed unwinds its balance sheet.

Today’s news buttresses our view that the driver of higher interest rates over time will be higher real interest rates. Real interest rates must move higher because they’re significantly below the long-term average, largely because of government intervention.

The creditworthiness of the US government should be an important component of real interest rates. The S&P report certainly highlights the risks of weakening credit fundamentals for the US government, which, in and of itself, should led to higher interest rates.

If 10-year Treasuries yield about 3.5 percent and year-over-year inflation runs at about 2 percent, the real interest rate should be about 4.5 percent. That’s only half the long-term average. Meanwhile, one would expect a migration to higher real interest rates over time as the fundamentals of the US government weaken.

Is there a real risk that the US might default on its debt?

Moody’s released what I would call a rebuttal to the S&P statement. The ratings agency emphasized its view in the report’s title, ‘Shift in US Budget Debate is Positive Despite Uncertainty Over Outcome.’

Additionally, there was an early selloff in Treasuries on the day of the S&P report, but by the end of trading, Treasury prices rose and yields fell. That’s probably a somewhat rational outcome if one expects the S&P report to start a genuine conversation in Washington about how to tackle the US debt.

The Moody’s report stated that even a technical default may not lead to a ratings downgrade. If the US government fails to increase the debt ceiling on a timely basis, it would lead to a default of debt and perhaps a government shutdown. But this wouldn’t lead to a downgrade in the US debt rating.

It’s remarkable to think that an issuer could default on its obligations and remain AAA-rated, but in this event all creditors ultimately would be made whole. The US government is and will remain the benchmark of a credit-risk free asset globally, despite its fiscal weakness.

If the world’s best example of a credit-risk free asset has a weakening credit profile, this fact in and of itself should lead to higher real interest rates, not just in US Treasury assets but across all bond markets. Those higher rates could have negative consequences for virtually any financial asset, save gold.

Would investors be better served by looking to foreign bonds?

In certain cases, yes. But the credit conditions found in peripheral European countries, for example, are significantly worse than the risk profile that we face domestically. We would caution any investors from arbitrarily moving overseas to avoid US Treasuries. It may seem counterintuitive in an environment of weakening US government fundamentals, but Treasuries could prove to be a safe haven investment because the US economy remains the world’s largest economy. If the US economy weakens because of its debt levels, it would still outperform many other global economies on a relative basis.

It’s just a very challenging global economic environment, but that doesn’t mean that Treasuries are a poor investment. In fact, in this environment, the US bond market is relatively attractive.

What is the significance of recent news that famed investment house PIMCO is betting against Treasuries?

Yields are low and likely to rise over time, which warrants a defensive posture. Nonetheless, pockets of opportunity remain in fixed income. We’ve argued for some time that US monetary policy has led to an artificially low interest rate environment but has also resulted in a steep yield curve that provides some opportunities to investors. These steep treasury yield curves have historically allowed longer-duration issues to outperform.

However, the current situation is somewhat atypical. Not only are we experiencing a historically steep Treasury yield curve, we also have very steep corporate spread curves. In other words, investors are being compensated for taking on credit risk further out on the curve.

Generally a steep Treasury curve is consistent with expectations for strengthening economic fundamentals. That usually means that investors require less additional compensation to take on credit risk. In contrast, the current environment is characterized by very steep spread curves. On average you need 1 percent of additional yield to lend money to a corporation for 10 years. Now you typically need closer to 1.4 percent of additional yield to encourage investors to lend further out on the curve.

This means that lending money to a corporation for 10 years would require a yield of about 4.5 percent, whereas at the long end of the curve, corporations face financing costs of more than 6 percent. Consider the situation. We have an exceptionally low interest rate environment that requires yields above 6 percent to lend to investment-grade companies. Furthermore, this follows a dramatic improvement in corporate balance sheets. This is a relatively attractive investment opportunity, especially in contrast to the 0.5 percent yield that the US government will offer investors for two years.

Investment-grade securities are the sweet spot for bond investors today. The additional compensation that investment grade securities offer relative to alternative investments is attractive. Although you can receive a higher yield by investing in junk bonds, the risks of those higher yields offset the benefits.

Did the Fed intend to encourage the assumption of more credit risk?

One could argue that the Fed engineered a dramatic recovery in equity valuations. The Fed has also engineered a recovery in junk bonds but less so in investment grade securities. Through March 2010, the Fed purchased $1.75 trillion in securities, all of which were Treasuries, agencies and mortgage-backed securities. The asset class it didn’t purchase was investment-grade corporate bonds.

Investment-grade corporate bonds didn’t directly benefit from the artificial demand that came from the US government. Consequently, investment-grade corporate debt is the one opportunity within the bond market that still offers some relative value and fair compensation for investors.

 Additionally, when the Fed unwinds its balance sheet, this move will impact investment grade corporate bonds the least. Corporate bonds have also historically outperformed when interest rates rise, which we expect to happen when the Fed’s second round of quantitative easing ends.

We expect to enter a phase we describe as “passive tightening” before the end of the year. Passive tightening is an environment where the Fed’s balance sheet shrinks as a result of pay downs and maturities.

For example, if the Fed holds $3 trillion in its portfolio and over the course of the next two years $1 trillion worth of those assets mature, the balance sheet effectively shrinks by one-third without taking any action.

What are the odds of a rate hike in the near future? Will the Fed restrict itself to passive tightening?

The Fed won’t need to move the targeted Fed funds rate before the end of the year. However, the Fed can utilize a number of unconventional tools, and the central bank has stated its ability to tighten monetary policy before moving the Fed funds rate. If you focus on the targeted Fed funds rate in order to know when monetary policy is tightening, you’re going to miss the show. Fed Chairman Ben Bernanke recently noted that the Fed can change the interest rate paid on reserves and begin engaging in reverse repo transactions to tighten monetary policy. As a result, we could see higher short-term yields across the entire bond market even as the Fed funds rate remains at its current level. That’s what will happen as the Fed tries to flatten the yield curve.