Should You Plan for a Default?
Congress is debating whether to raise the debt ceiling, the maximum amount the U.S. Government can borrow by issuing bonds. If the debt ceiling is not raised, the U.S. Treasury Secretary Janet Yellen estimates the Government would have to default on payments by June 1. That potentially includes interest payments on government bonds and all other payments by the government. The largest expenditures the Government makes are on Medicare, Medicaid, Social Security, and Defense.
Taxes (and some smaller sources of income) pay for a substantial portion of Government expenditures. But expenditures are significantly larger than incoming tax receipts, creating a shortfall or deficit. To cover the deficit, the Government borrows money by issuing debt securities, including Treasury Bills, Notes, and Bonds.
Congress imposes a limit on the amount the Treasury can borrow, called the debt ceiling or debt limit. The US Government reached the current debt ceiling earlier this year. Expenditures that exceed income are now being covered by various cash reserves. For the Government to continue borrowing, Congress needs to raise the debt limit. If Congress is unable to raise the debt limit, the Government would only be able to use incoming receipts (taxes) to pay for expenditures.
Historically, Congress occasionally refused to raise the debt ceiling to force a President to reduce or increase spending in specified areas. The US came so close to defaulting in 1995 and 2013, that the Government needed to shut down. However, the US has never actually defaulted on its debt.
It seems ridiculous that something so devastating would be treated as a political weapon but that is the situation today. So, a default is more likely than in the past.
What to Do?
It is difficult to plan for a default because we don’t know how it would unfold. What we do not know includes:
- Whether and when a default might occur;
- Whether the default would last a few days or for an extended period;
- Whether all federal payments would be suspended or some – such as Social Security, Medicare and Department of Defense – would be continued;
- Would money owed by the government because of default be paid once the default ended; and
- How damaging the default would be to the US and world economies.
A default that lasted one or two days might not be catastrophic but it would damage the reputation of US bonds. That would probably depress bond prices and raise interest rates for an extended period. For an explanation of the relationship between bond prices and interest rates, click here.
An extended default could be catastrophic.
In my lifetime, the two most damaging financial events were the 2007-2009 Great Recession and Covid. An extended default could be worse than either of those. The stock and bond markets would probably crash, many sources of income (Social Security, government pensions, government payments to the private sector for goods and services, Medicare and Medicaid) would be suspended, interest rates would increase to much higher levels and businesses that depended upon loans (auto, home) would see demand plummet. The U.S and world financial systems would be at risk since the safety of US Government bonds is one of the bedrock principles.
Because the potential effects are so catastrophic, the likelihood is low. Political pressure to end a default will be enormous. However, the possibility of a default seems higher than at any time in the past.
- Our most important suggestion is to have sufficient emergency funds to pay expenses if income from Social Security, salaries and pensions were suspended. Emergency funds include readily available cash in your bank accounts and access to credit, such as a Home Equity Line of Credit or credit card.
- Both the stock and bond markets would probably decline, so it would not be a good time to withdraw from investment accounts.
- Selling investments in anticipation of a default is unlikely to be a good choice. Even if a default occurs, details, timing and effects are unknown. Historically, it was better to stay invested during catastrophic events (2007-09 Great Recession and Covid in 2020) than to try to time the markets. Of course, past performance is no guarantee of future performance.
Individual situations vary, therefore the suggestions above should not be relied upon as individual advice relevant to you or any other person.
This is for educational purposes only. To learn more about the topics mentioned and if they are suitable for you, consult an appropriate professional. Tax laws can change at any time.
Any information provided in this presentation has been prepared from sources believed to be reliable, but is not guaranteed and is not a complete summary or statement of all available data necessary for making an investment decision. Any information provided is for information purposes only and does not constitute a recommendation.
Arthur Stein and Arthur Stein Financial, LLC are not authorized to give legal or tax advice. For information on your specific situation, please consult your tax advisor regarding any tax implications and your attorney for legal implications. As required by the US Treasury Regulations, you should be aware that this presentation is not intended to be used and it cannot be used for the purposes of avoiding penalties under federal tax laws.
Keep in mind that:
- Past performance is no guarantee of future performance;
- Investments involve the risk of loss of principal and earnings;
- ETFs, mutual funds, money market funds, etc. are not guaranteed by the US Government, the FDIC, a bank or anyone else.
- “Average annual return” evens out variations in the actual year-to-year returns.
- ETFs, mutual funds and individual stocks and bonds fluctuate in value and there will always be times when they lose value.
- None of the information provided is necessarily relevant to anyone’s personal situation. Circumstances differ among individuals and you should not assume that these generalizations or information apply to you.
- Investments mentioned may not be suitable for all investors.