Every investor should be afraid of a U.S. government debt default. But tearing a portfolio apart because of the risk of a default is risky, too.
A U.S. default would be catastrophic.
Even one day in default would harm the nation's credit rating, and have serious ripple effects, including:
• Damage consumer confidence, and possibly the economy.
• Cause interest rates to spike higher.
• Hurt stock and bond prices.
• Wound the value of the U.S. dollar on international currency markets.
Already on Monday morning, 10 days before the default deadline of Oct. 17, the Japanese stock market has fallen more than 1%, and the value of the U.S. dollar has fallen sharply against major currencies. Futures on the Dow Jones industrial average were down 132 points at 7:30 Monday.
And default would be an inexpressibly stupid event.
The debt limit isn't a law that prevents Congress from authorizing new expenses, such as building a dam or an aircraft carrier. And it doesn't cover government activities that are largely self-funded –- including the Affordable Care Act, which is the reason for the current stalemate. Rather, it allows Congress to pay the bills on spending it has already authorized, from building leases to Medicare payments to interest and principal on the national debt.
It's the latter that most worries the financial markets.
Treasury secretaries, both Democratic and Republican, are clear about how bad a default on the debt would be. Jacob Lew, the current Treasury secretary, said in a letter to Congress in September:
"The debt limit impasse that took place in 2011 caused significant harm to the economy and an unheard of downgrade to the credit rating of the U.S.. The drawn-out dispute caused business uncertainty to increase, consumer confidence to drop, and financial markets to plunge. If Congress were to repeat that brinksmanship again this time, it could inflict even greater harm on the economy. And if the government should ultimately become unable to pay all of its bills, the results could be catastrophic.
Henry Paulson, Treasury secretary under George W. Bush, said this about a default in an interview with National Public Radio last month: "As a former Treasury secretary, I take the view that it is unthinkable that Congress wouldn't live up to our commitment to make good on past spending commitments and obligations," he said.
By not increasing the debt limit, the nation would have to rely on cash on hand – as well as some accounting sleight of hand – to function, and even then it would run into problems, possibly as early as Oct. 17. By Oct. 30, a default on Treasury securities, regarded as gold-plated worldwide – would be nearly inevitable. On that date, the U.S. will be short about $7 billion what it owes its creditors.
Default could come more quickly than Oct. 30 if investors in Treasury bills decide not to reinvest their money, requesting their principal back instead. Investors roll over about $100 billion in T-bills every week.
What could happen to your investments in a default?
• In the credit markets, those with poor credit ratings pay higher interest rates, and there's no faster route to a bad credit rating than missing a payment. In order to convince investors to buy Treasury securities, the U.S. would have to offer higher interest rates – which, in turn, would make borrowing for home buyers and businesses higher at the same time.
• For bond investors, a sharp rise in interest rates is pure poison. When interest rates rise, the price of existing bonds fall, and vice-versa. Analysts use a measurement called duration to figure out how badly a bond will be hurt by an increase in rates. A bond fund with a duration of five years, for example, will lose 5% of its value if interest rates rise one percentage point.
With rates at current levels – the 10-year Treasury note yields a low 2.6% -- reinvested interest would provide very little cushion against price declines if interest rates rose.
• Stock investors would also be hurt by rising rates and a weakening economy. Higher interest rates mean that bank CDs and other, safer investments would be tougher competition for dividend-paying stocks. And a weakening economy would pose a threat to corporate earnings.
• The value of the dollar would also take a hit. Investors would be likely to sell U.S. dollars on the currency market, pushing down the value of the sawbuck against other currencies. If confidence in the dollar falls enough, it could lose its status as the world's reserve currency – a tremendous advantage. When the U.S. issues bonds, it pays interest in dollars. If the nation had to issue bonds payable in, say, euros, it could find itself in a tough spot if the euro soared in value.
What can an investor do? That depends upon how much confidence you have that Congress will fix its own self-inflicted problem. Markets will probably sell off as the deadline looms. If there's a last-minute resolution – as there was in 2011 – stocks and bonds should soar in value, as should the U.S. dollar.
If you're gambling on a default – and gambling is the precise term, because you're making a decision based on something as unpredictable as Congress – then you'd want to either move money from stocks into bank deposits, or invest in funds that rise when stocks fall, such as the Rydex Inverse S&P 500 Strategy fund (RYURX).
International bond funds, which get a boost from a falling U.S. dollar, might be another way to play a default. (International stock markets would probably fall along with Wall Street). And gold, the ancient all-time cure-all for a collapsing currency, could also be a hedge. Bear in mind, however, that if rates rise and the economy tumbles, gold might not rise with it. Gold pays no interest, and thrives the most in an ultrainflationary period. You usually don't get high inflation in a recession.
Sophisticated investors could buy puts on stocks or stock indexes. These are the right, but not the obligation, to sell a stock at a set price, and become more valuable as stocks fall.
The danger with any or all of these moves is that if you miscalculate, you could miss a significant rally when the U.S. starts to get its financial house back in order. You could incur significant capital gains taxes if you sell stocks or mutual funds that have gains. And if you invest in hedges, such as inverse funds, you could take significant losses if your fears don't materialize.
And even if you're right and the U.S. defaults, you run the risk that the financial markets will not function normally -- if at all. You'll be living in a world where you're far more likely to lose your job than you are today. Your best investment now might be to write to your Congress and tell them they'll be looking for a new job if the nation does default.