Debt deadline: What happens, what you should do

9:46 AM, Oct 16, 2013   |    comments
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John Waggoner, USA TODAY

USA TODAY - As the deadline to default ticks down, you need to know how it will affect you, and how it will hit your portfolio.

Hitting the debt limit isn't, as some have cast it, "cutting up the nation's credit cards." The more apt analogy would be cutting up the credit card bill and refusing to pay for things you have already bought.

The debt limit is a peculiar law that limits the amount the United States can pay for money that has been authorized by Congress -- the same people who are railing against government spending. And the longer before the U.S. raises the limit, the more people it affects.

Even without passing the limit, the nation's borrowing costs are already rising. The U.S. issues Treasury securities in order to borrow: Treasury bills, notes and bonds are simply IOUs backed by America's promise to repay. When a lender suspects you might not pay on time, it will demand a higher interest rate.

That's happening right now. For example, a three-month Treasury bill that matures Oct. 24 -- seven days after the date the Treasury says the nation will be out of money -- now yields about half a percentage point. While that may not seem like much, the rate on that issue at auction was 0.005%.

Standard & Poor's has already downgraded the nation's credit rating during the last tussle over the debt limit, saying that political brinksmanship was incorporated into the nation's less-than-perfect AA+ rating. On Tuesday, Fitch said it was considering lowering the nation's credit rating as well. Should the U.S. actually default, S&P would lower its rating to "selective default," since nations, unlike companies, typically don't default on all their debts at once.

Were the U.S. to actually default, you could expect other interest rates to rise, such as the rate on the 10-year Treasury note, because lenders would worry about being repaid. Rising rates would hit prices on bond mutual funds. Americans have $2.8 trillion invested in taxable bond funds, according to the Investment Company Institute, the mutual fund industry's trade group.

Bonds wouldn't be the only victim. Rising rates means tougher competition for stocks from other investments, and would undermine investors' faith in the economy. The value of the dollar would also fall on world markets, as investors sell dollar-denominated investments for other investments less likely to default.

Rising rates would also rise for other borrowers, since many other rates, such as mortgage rates, key off Treasury rates.

But Treasury borrowers aren't the only ones affected by default. The debt limit applies to all government spending -- Social Security payments, Veterans benefits, even military pay. The government shutdown alone shaves 0.3% a week from fourth-quarter GDP, according to John Chambers, chairman of the Sovereign Debt Committee at S&P, speaking on CBS This Morning. Shutting down payments altogether would be "worse than Lehman Brothers in my judgment, and I think it's needless," Chambers said.

What's an investor to do? As bad as the situation is -- and it's bad -- you need to think carefully about selling your stocks and bonds. If you're investing in a taxable account, you'll trigger capital gains taxes. You may also owe commissions and fees on selling your holdings.

You'll also have to think about where you'll put your money when you sell. If your sales go to a money market mutual fund, you need to be aware that a staple of money funds is Treasury bills. While many funds have taken steps to rid themselves of the most default-prone T-bills, a lengthy default could hurt money fund returns as well.

Other possible moves:

• Consider an inverse fund, which rises when stocks fall, and vice-versa. These funds use futures and options to go in the opposite direction as stocks. Rydex Inverse S&P 500 Strategy fund (ticker: RYURX) is one of the best-known inverse funds.
• Consider buying put options on the S&P 500. A put option is the right, but not the obligation, to sell stocks at a set price. A put option to sell the S&P 500 at current levels would soar if the stock market dropped 10%.
• Consider international bond funds. International stock funds will likely drop along with the U.S. markets. And a default will send the world bond market in turmoil. But a falling dollar is good for investors in international securities.
• Take your risks with a money fund. Even if a money fund let its share price drop below $1, the loss would likely be small. Reserve Fund, the money fund that broke the buck during the Lehman Brothers crisis, saw its share price fall to about 97 cents. But some shareholders had to wait before getting their hands on their money.
• Jump in to the markets in the event of a steep decline -- 5% or more. Big downdrafts tend to focus Congress' attention, and the bounceback rally could be considerable.

Gold is a mixed bet. On the one hand, gold moves in the opposite direction of the U.S. dollar. On the other hand, default could send the nation into recession, which would make inflation unlikely.

All of these strategies have drawbacks. An inverse fund or a put option will get smacked if Congressional leaders emerge with a compromise that allows the country to pay its bills. And if you're sitting on big capital gains - as many are during the past five years - you may have to peel off 20% to Uncle Sam. If your gains are short-term - less than one year - your taxes on your gains will be the same as your income tax rate.

USA TODAY

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