Many economists agree that a federal default would be catastrophic. If Congress refuses to raise the debt ceiling, which House Republicans have threatened to do unless President Joe Biden’s administration grants them certain policy concessions, the economic damage could be swift and severe. Moody’s Chief Economist Mark Zandi has testified, for example, that default could include a deep recession and up to 7 million jobs lost.
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At the same time, federal payments would begin stuttering to a halt. Depending on how long a default continued, the Treasury Department could miss interest and debt service while federal paychecks, benefits and other payments would be at risk. While the debt ceiling debate has historically played like high political theater, the combined one-two punch of soaring unemployment and missed federal payments would have a very real impact on households. So, for individuals and financial advisors, the question is: what next?
To understand how advisors should be addressing clients’ default concerns, SmartAsset reached out to Atul Bhatia, fixed-income portfolio strategist with RBC Wealth Management. And his main advice is simple: Don’t panic.
The U.S. Debt Default
In January, government spending hit the federal debt ceiling. This is a World War I-era procedural rule by which Congress sets a limit on how much the Treasury can borrow at any one time. If the national debt reaches this limit, Congress must specifically raise it before the Treasury can continue borrowing money to pay its bills.
The problem with the debt ceiling is that, despite its name, it has no relationship with how much money the government owes. The Treasury issues debt to raise money with which it pays existing bills and creditors, spending that is established through past budgets and borrowing.
If Congress refuses to raise the debt ceiling, the government will still owe this money to assorted bondholders, contractors, federal employees, Social Security recipients and countless others. But it will not have the cash to make those payments and will, instead, begin to default on those bills.
Why Clients – and Advisors – Shouldn’t Panic
“Our take is that they’re not going to default. And if they’re not going to default, this just becomes (about) how high is the volume going to become on the noise,” Bhatia says.
“The message we’re sending is: The U.S. is not going to default. We don’t see that as an on-the-table option.”
That doesn’t mean that the debt ceiling conflict means nothing. There is a very real cost when a borrower, any borrower, talks about not paying their bills. The more often, and more loudly, an institution threatens to default, the more nervous it will make future lenders. All of this is relevant, but it doesn’t mean financial advisors should prepare for stopped payments and missed paychecks.
Instead, there are two major concerns when it comes to the federal debt ceiling. The first is how this would affect individuals through a recession, unemployment and missed payments. Second, how it would change an investor’s perspective on U.S. debt. In both cases, Bhatia’s team has taken the same position. Individuals do not need to begin taking extraordinary measures in anticipation of job loss, no more than they should for ordinary financial planning. And investors don’t need to begin planning around a collapse of Treasury debt.
Advisors Should Remain Consistent on Portfolio Construction
In the context of investments, particularly, Bhatia’s team does not recommend that financial advisors change their positions on portfolios and portfolio construction. Treasury bonds should still be treated as a safe asset class and included in client portfolios for the same reason as always, regardless of the politics around the debt ceiling.
“The question becomes ultimately, do you flee the asset class?” Bhatia says. “And I don’t think you can rationally decide, ‘I am going to flee U.S. Treasurys because I don’t like what is happening, even though (U.S. Treasurys) give me a downside protection that I can’t easily find elsewhere.’”
In the short term, Bhatia and his team still see the Treasury bond market as reliable. In part, this is because there simply is no substitute for them on the market. They are reliable assets, and they define the rest of the bond and debt-based markets as the investment that you will always receive payment on. Bhatia’s team at RBC is not changing its position on that, and they don’t recommend financial advisors doing so either.
“What is going on with the debt ceiling is noise, (and) in times of insecurity people flee to the dollar and U.S. Treasurys,” Bhatia says.
It’s that flight that defines the other part of the short-term market. If anything, the uncertainty created by the debt ceiling might be good for the value of U.S. Treasury debt, Bhatia says. While they are not treating default as a realistic option, Bhatia’s team does see potential uncertainty around the politics of this. And in times of uncertainty, investors often move their money into Treasury debt as a safe asset.
If anything, this might make Treasury debt more valuable for a portfolio, not less, he says.
Risks Surrounding the Threat of Default
To be clear, though, Bhatia’s team at RBC does see some long-term risk around the threat of default. That’s not the possibility of default, just the threat of it, he says. This is the cost associated with borrowers talking about not paying their bills. As Congress threatens to default on its debt payments, lenders and investors might begin to diversify their assets away from this kind of political chaos.
“When we’re thinking about portfolios and the construction of them … there is a cost,” Bhatia says. “We are a borrower nation, but we keep giving people reasons to think about going somewhere else when it comes to lending their money.”
The takeaway for folks here may not be a total aversion to U.S. dollars. But, at the margin, they may start thinking, “Man, I should hold a few more euros,” Bhatia says.
This is the kind of slow erosion of value that doesn’t pose an urgent threat but will emerge year after year. This probabilistic risk is very real, but it is also not an immediate issue for households planning their future.
For financial advisors addressing their clients, the answer here might be straightforward. “Don’t panic, and don’t prepare for the worst. This will probably blow over.” In the meantime, take note of some of the long-term risks associated with the rhetoric surrounding U.S. debt default.
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