What Will Happen to Bonds if the Debt Ceiling Isn’t Raised?

Traditionally all interest rates have been tied to the rates paid by US Treasuries and Notes.  One would therefore expect bond prices to fall, and the interest rates paid by corporate bonds to rise, should the debt ceiling not be raised and the credit rating of the US declines, causing the interest rates demanded of US debt to rise.  In fact one might expect the interest rates of everything to rise, causing borrowing costs for everyone to rise, resulting in layoffs, decreases in business purchases, dogs sleeping with cats, and financial Armageddon.  But not so fast.

First of all, a failure to raise the debt ceiling would not necessarily result in a default or a decrease in the US credit rating.  Because the interest on current debts is only about 10% of current revenues, the US could easily continue to pay the interest on the debt even without additional borrowing as long as making the interest payments was a high enough priority.   One would assume that avoiding a default would be a top priority since defaulting would result in the need to pay much higher rates for future borrowing.

Like a borrower who goes deeper and deeper into debt, if the US continues to raise the debt ceiling and continues to take on more debt, that might actually be more likely to cause the credit rating of the nation to decline.  As one knows, one cannot keep borrowing indefinitely to maintain one’s standard of living.  Eventually the interest payments on the debt will become so big one can only afford to pay interest and nothing else.  Likewise, continuing to borrow to pay for interest and current programs will only decrease the credit worthiness of the country.   The debt is already more than 80% of GDP – the “salary” of the US.  Once it reaches about 120%, the chance of avoiding a Greece-style default become slim to none.  The warnings issued by the credit rating agencies recently were not that the debt ceiling might not be raised, but that the size of the deficit was continuing to grow such that the debt was becoming unwieldy.

Second of all, the rate on corporate bonds may not necessarily rise, or conversely the price of corporate bonds fall, if the rates on US treasuries rise because of a decrease in the country’s credit rating.  While it is true that bond rates and other consumer rates tend to be tied to the rates on Treasuries, such that rates will increase if the Federal Reserve starts sucking up available cash and driving up Treasury Rates, the rates on corporate bonds would not necessarily rise if the cause of the increase in US Treasury rates was due to a decrease in their safety.  The reason that bond rates rise if the rates on Treasuries rise now is because Treasuries are considered the safer investment.  If one can get 5% from a “safe” Treasury, one would not buy a “less safe” corporate bond unless one received a higher return –  8% in interest, say.

If Treasuries became less safe, however, the price premium enjoyed by Treasuries might disappear, meaning that corporate bonds might pay the same interest rate. In fact, investors looking to sidestep a US default might move their money into corporate bonds, causing corporate bond rates to actually decrease and the price of corporate bonds to rise even as the prices on Treasuries fell.  Note that stocks would also rise in this case.

The biggest risk for corporate bonds in the event of high levels of US debt would be hyperinflation.  For example, if the US started printing money to pay off its debts, thereby devaluing the currency.  The fact that gold prices have risen so much lately, and the fact that the Canadian Dollar is now worth more than the US dollar,  indicates that the dollar has undergone significant devaluation.  To guard against some of the risks of hyperinflation, one can include US stocks and foreign stocks in one’s portfolio.  While US stocks would take an initial hit should hyperinflation occur, share prices would eventually rise with inflation.  This is because the “value” of the companies would be maintained – the ability to sell lots of computers, hamburgers, or business services,  would still be a valuable thing – so more dollars would be needed to buy shares if dollars were becoming worth less each day.

So, a failure to increase the debt ceiling would not necessarily be a bad thing for corporate bonds.  A continuation in the increase in US debt is more worrisome since it could lead to hyper-inflation, which would cause bond prices to drop.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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