Raising the Debt Ceiling

July 28, 2011

Will politicians agree to raise the debt ceiling? Or will the government default on its debt? Regardless, if the government cannot pay its bills on time starting August 2nd, it will be a temporary situation.

A failure to raise the debt ceiling by August 2 does not mean the U.S. will forego all payments for its obligations. Tax revenues will still be coming into the U.S. Treasury, although not enough to meet all the obligations in a timely manner. Much like a struggling household that has more bills to pay than available income to pay it, if additional borrowing is unavailable the federal government will prioritize which obligations are paid first and which ones are postponed. (Our recommendation would be to begin cutbacks by stopping salaries for elected politicians until they reach a resolution. We suspect if their paychecks ceased the problem would be resolved quickly.)

Unlike Greece, the U.S. issue is not whether creditors will be paid principal and interest due. Here’s why --- The yield (interest rate) on three year U.S. Treasury notes is 0.66%. Now compare that to Greek three year bonds with rates north of 30%. If there were a serious threat of a U.S. default --- as in getting stiffed for principal or interest instead of a short delay --- it would show up as sharply rising interest rates for U.S. Treasury instruments. That’s not the case.

So the marketplace, via interest rates, is implying there’s a high probability that Greece will default (unable to repay its debt and interest) and no chance of the U.S. defaulting and not paying its debt and interest.

The U.S. government had a similar experience in 1995 when the federal government was shut down for a few days. The situation was negative at first, but quickly reversed once there was a solution. And, there was no sustained impact on market interest rates.

We have been asked if there is an investment “Plan B” in the event the U.S. defaults. Will we do something radical if the debt ceiling is not raised by August 2nd? No.

Keep in mind the four guidelines of successful investing: balance, diversification, moderation and patience. A radical change would violate the third guideline, moderation. Our experience and observations find that every time one of the four guidelines is violated, it is invariably the wrong thing to have done.

If we make a radical move in anticipation of an event that doesn’t happen, or that lasts only a few days, the results will be worse (i.e., more costly) than riding out a brief distraction.

For these reasons, we will hold our current moderate and well-diversified portfolio.

The negotiations in Washington have become a spectacle of posturing in anticipation of the 2012 elections. The best part is that the problem of excessive deficits and a burgeoning national debt is now at the forefront of the American public’s attention and must be addressed.

Please don’t hesitate to call us if you have questions or would like to discuss this further. ***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2011