October 15, 2013

The deadline to raise the U.S. government debt ceiling is rapidly approaching, but Congress has not yet agreed to authorize an extension. Breaching the debt ceiling, which may result in a default, could have major ramifications for the government, the economy, and the financial markets. Indeed, the very discussion of such a possibility has affected the bond market, where the costs of insuring against a U.S. government default—as indicated by the prices of credit default swaps—have risen sharply in recent days.

Background and Basics

What is the statutory (legal) debt ceiling?

Under current law, Congress authorizes the U.S. Treasury Department to issue the debt securities needed to fund federal government operations up to a stated limit, or ceiling. The current debt limit is $16.699 trillion; it was increased to that level earlier in 2013.

Why was the debt ceiling not a concern earlier this year?

Due to the economic recovery, higher tax rates at the beginning of 2013, and federal spending cuts (i.e., the sequester) that took effect in March, the federal government has had higher-than-expected revenues and a smaller-than-expected budget deficit during this fiscal year. The budget is still far from being balanced, however, and the government's aggregate debts—while growing more slowly than previously—are still mounting.

How will the Treasury operate if the debt ceiling is not raised?

Without a debt ceiling increase, the Treasury will have no authority to borrow additional money to finance daily federal government expenditures. If this happens, the Treasury would have to align spending with revenue, which would require an immediate and significant reduction in spending. Based on the Congressional Budget Office projections on government revenue and expenditures for 2014, failure to raise the debt limit would require the government to cut spending by 15% to 20%.

In the absence of lifting the debt ceiling, are there any actions the Treasury can take to avoid missing interest or principal payments on Treasury securities?

Even if the debt ceiling is not increased, the Treasury will continue to receive tax revenues that could be used to service the interest on the national debt. That would require prioritizing debt-servicing expenditures over others. The Treasury can also continue to auction debt securities on a regular basis, but only to replace maturing issues so that there is no net increase in government debt. In addition, according to a 1985 report from the Government Accountability Office, "the Treasury is free to liquidate obligations in any order it finds will serve the interests of the United States." At this time, significant asset liquidation seems unlikely.

Is the Treasury likely to prioritize some of its obligations?

It is unclear how the Treasury will act if the debt ceiling is not lifted in time. The Treasury could defer nonfinancial expenditures (e.g., Social Security payments) in order to maintain debt service, but it does not have a clear legal basis for doing so. Legislation passed by the House of Representatives in May would permit the Treasury to prioritize its payments, but the bill has not been passed by the Senate. Also, in his recent letter to Congress, Treasury Secretary Lew referred to prioritizing some payments over others as "simply default by another name."

How would rating agencies respond to a U.S. government default?

S&P has already warned that it would lower the U.S. sovereign rating to Selective Default if the government fails to service a debt obligation. Similarly, Fitch could reduce the rating to Restrictive Default.

Even if the debt ceiling is raised in the near future, could there be another downgrade of U.S. government debt?

T. Rowe Price sovereign credit analysts believe a credit rating downgrade could occur in any of these three situations:

(A) The agencies reassess U.S. political institutions and the "willingness to pay," determining that it is no longer consistent with their current rating (currently AAA for Moody's and Fitch and AA+ for S&P). A downgrade could be one to two notches.

(B) As we get close to the debt ceiling, the agencies may preemptively change the outlook on the rating, or downgrade it slightly, to reflect the elevated risk environment.

(C) If the U.S. actually defaults, then the U.S. would be downgraded to a default rating.

What is the difference between a default and a credit rating downgrade?

A default takes place when an issuer of debt securities (i.e., a borrower) fails to make the required interest or principal payments to bondholders on a timely basis.

A credit rating downgrade takes place when a credit rating agency—such as S&P, Moody's, or Fitch—determines that the ability of a borrower to make timely interest and principal payments is weakening. In August 2011, immediately following the debt ceiling crisis, S&P downgraded the U.S. government's long-term sovereign credit rating from AAA to AA+. S&P cited the weakened political environment and political brinkmanship as the main triggers for the downgrade.

If the debt ceiling is not raised by the deadline, will Social Security payments be affected?

The Obama administration has not indicated how it may prioritize spending if the debt ceiling is not raised. It is assumed that Social Security would remain a high priority.

Possible Financial Market Responses

How would Treasuries and other government-backed securities respond to a U.S. government default or downgrade by one or more major credit rating agencies?

A one-notch downgrade of U.S. Treasuries would likely create short-term market volatility. However, on its own, it would not be the catalyst for a crisis. Some believe that U.S. Treasury yields could rise, and other government-backed debt securities—such as GNMA, Fannie Mae, Freddie Mac, and Sallie Mae securities—could be affected, too. But that outcome is not assured. Treasury yields actually fell sharply in the months that followed the August 2011 downgrade, though there were other factors—such as the eurozone debt crisis—that likely contributed to the decline.

A default would be a much more serious problem, but we believe this outcome is highly unlikely at this time. In a default scenario, U.S. debt could be rated D for some period, and forced sales of Treasuries by investors would probably create high volatility and illiquid market conditions.

Would the Treasury market still be considered a safe haven in the event of a downgrade?

It is likely. The fact that longer-term Treasury yields have been declining over the past two weeks despite the threat of a government shutdown and another possible debt ceiling crisis is a reassuring signal that foreign investors continue to favor the liquidity and low risk of U.S. Treasuries.

Would higher Treasury yields lead to higher bond yields (and thus, lower bond prices) in other sectors of the U.S. bond market?

Over the long term, we believe that the economy, inflation, and the Federal Reserve's monetary policy will be the primary drivers of interest rate movements. If Treasury yields rise in response to a credit rating downgrade, yields on other securities that are backed by the full faith and credit of the U.S. government or linked to its rating (such as Ginnie Maes) would probably rise, and the yield spread (difference) between Treasuries and these sectors could increase modestly.

Would the Treasury market become less liquid in the event of a downgrade?

The Treasury market is perhaps the most liquid market in the world. Although a downgrade could result in reduced overall liquidity, it is expected that those who wish to buy or sell Treasuries after a downgrade should generally be able to do so without difficulty.

Could the U.S. dollar lose value relative to foreign currencies?

It is possible, particularly if foreign investors who own Treasuries or other dollar-denominated assets redirect their investments to nondollar-denominated securities.

How would global fixed income markets respond to a U.S. government downgrade?

It is uncertain how global fixed income markets would respond to a U.S. downgrade. However, there could be a flight to quality—at least for a short time—in which investors sell or avoid higher-risk assets in favor of high-quality fixed income assets globally or other perceived safe havens.

How would global equity markets respond to a U.S. government default or downgrade?

It is uncertain how global equity markets would respond to a U.S. downgrade or default, but we believe a default is highly unlikely at this time. In the event of a downgrade, there could be a flight to quality—at least for a short time—in which investors sell or avoid higher-risk assets in favor of high-quality fixed income assets globally or other perceived safe havens. That is what we saw in 2011, specifically in emerging markets. A default would have much greater repercussions.

What should investors do in this uncertain environment?

T. Rowe Price's financial planners strongly encourage investors to stay focused on the long-term goals for which they are saving—such as retirement or college—and have an appropriate and broadly diversified asset allocation. This is preferable, rather than attempting to time the markets or making portfolio adjustments every time the market gyrates. Reacting to short-term market events could derail your long-term investment goals.

Before making any significant strategy changes, it would be prudent for investors to review their portfolios to determine if the allocations reflect their tolerance for volatility and the time horizons of their financial goals.

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of October 7, 2013, and may have changed since that time.