The Debt Ceiling Debate

[Cindy Knowlton] Greg, we’ve seen the recent headlines about our government reaching a limit on how much it can borrow…referred to as the “debt ceiling”.  The reports suggest risks are on the horizon if Congress fails to take some sort of action fairly soon. Can you tell us more about what this debt ceiling is, and why it matters?

[Greg Hosbein] The debt ceiling is the total dollar amount the U.S. Treasury is allowed to borrow. It was first established in the early 1900s to simplify the borrowing process, so that every time the Treasury wished to issue debt, it would not have to get specific approval from Congress.¹ 

The U.S. reached its current debt limit of $31 trillion on January 19^th.¹ Although this should have already produced a default since we continue to run a deficit, Treasury Secretary Janet Yellen has various accounting tools to delay reaching a default point, but these measures can only last so long. Depending upon receipts and expenditures, the “real” limit may be reached by late summer although it’s difficult to know for sure.

Congress is on the clock until then to increase the debt ceiling by passing authorizing legislation. The particularly partisan tone in Washington D.C. currently, and the extremely tight balance of power held in each house of Congress, appears to have led to speculation about an impasse that may fail to resolve itself and this is reflected in the news regarding a potential default.

[Knowlton] Do you really believe the U.S. Treasury will default?

[Hosbein] We have been in this position 6 times in the last decade (that is, the Treasury using extraordinary measures)² and have not defaulted, so if history is a guide, I think the likelihood of a default is very small. A default would also likely be extremely harmful to the economic and financial markets, so there is enormous incentive for Congress to resolve this issue.

[Knowlton] Can you tell us why you believe investors should pay particular attention to this issue, and what the potential impact may be on the financial markets from the final debt ceiling agreement Congress passes?

[Hosbein] There are two reasons I think why investors should pay attention to this issue. First, as we approach the deadline, uncertainty may increase, which will likely lead to increased volatility across the financial markets broadly. Second, what comes out of Congress’ debt ceiling negotiations could, especially through any spending cuts, impact specific sectors of the bond market.

Exactly what that impact would be, we do not know. We have some guideposts, and many market observers point to the 2011 debt ceiling crisis when the U.S. was at the brink of default before an eleventh-hour agreement was reached between the two political parties. Like then, we now have a divided government. Like then, we are coming off a period of enormous fiscal spending (in 2011, it was in response to the Global financial crisis; in 2023, it was in response to the COVID pandemic).

The 2011 crisis led Congress to pass a complex deal that included significant future spending cuts. This eventually led to the Budget Control Act, which then led to across-the-board cuts in fiscal spending starting in 2013.³ During this period of negotiations in 2011, one of the major ratings services – Standard & Poor’s – downgraded U.S. debt. One would think that would result in an increase in the rates the Treasury would have to pay. The opposite happened – rates declined – primarily because expected fiscal restraint was anticipated to slow economic growth. For example, in the third quarter of 2011, the ten-year Treasury went from 3.18% down to below 1.8%.⁴

Corporate spreads widened dramatically, moving from a low of about 1.5% over Treasuries to well over 2.5% over Treasuries.⁵ This wasn’t solely because of the debt ceiling fight, as at the same time there was a sovereign debt crisis developing, notably in Europe.  But it did have an impact. Interestingly, S&P has not restored its rating of U.S. debt – it remains at AA+.

I think it’s worth noting that despite the debt ceiling crisis in 2011, bonds were actually a very good place in 2011. The return on the Bloomberg U.S. Aggregate Bond Index that year was 7.84% and the return for the Bloomberg U.S. Treasury Index was 9.81%.⁴

[Knowlton] Were there other parts of the fixed income markets that felt the effects of that post-Financial Crisis period?

[Hosbein] Yes. For example, the taxable municipal bond market was impacted in 2013 when the government implemented across-the-board spending cuts which resulted in a cut in subsidy payments to taxable municipal bonds issued under the Build America Bond Program.⁶ This cut triggered little known call features in many of these bonds, leading to a pretty significant widening in their yields relative to Treasuries.

Another sector hurt by the cuts were Grant Anticipation Revenue vehicle bonds, called GARVEE bonds. These bonds are municipal bonds used for transportation projects that rely heavily on anticipated revenue from the federal government. Rating agencies downgraded this sector once the budget cuts occurred.⁷

Last, the legislation passed in 2011 didn’t take effect until 2013. Because of this lag, Treasury Inflation Protection securities, or TIPS, performed very poorly in 2013. TIPs were down 8.6% compared to a 2.75% loss for Treasuries based on the Bloomberg Treasury Index.⁴

[Knowlton] Turning back to the present time, can you tell us how SBH is preparing now for the possible outcomes to the current debt ceiling debate shaping up in Washington?

[Hosbein] There are two ways we are preparing. Of course, there are no guarantees that any investor can successfully avoid the risks in the market. First, we are actively following the negotiations to gain clues as to what fiscal changes might be coming. Because there will likely be changes. We don’t want to own issuers heavily leveraged to the growth of government spending. What specific areas will be targeted, however, is still unknown.

The second way we are preparing is by continuing to review the credits we own, making sure the covenants are strong and the revenue sources are in-tact, and not heavily dependent on annual government spending growth. This is part of our fundamental research process which is focused on securities we believe will perform well over market cycles and offer downside protection.

While we believe it’s likely that the fixed income market will experience volatility in 2023 due to factors including the debt ceiling negotiation, we remain optimistic on the asset class and believe several sectors offer attractive investment opportunities.

[Knowlton] Before we wrap up today, Greg, can you share where you believe opportunities existing in the fixed income market today?

[Hosbein] Cindy, we believe there are many opportunities within the higher quality areas of the fixed income market.  For example, the yields available in shorter duration bonds, which are close to 5% in early March, are 4 percent higher than they were just 2 years ago.⁴  This yield provides a “cushion” to help protect investors against a loss of value that could occur should rates move higher.  For investors who have ignored fixed income markets because of the low level of rates, we believe it may make sense to revisit that allocation.

[Knowlton] Thank you Greg for sharing your perspective on the debt ceiling crisis.

¹https://www.crfb.org/papers/qa-everything-you-should-know-about-debt-ceiling

²https://home.treasury.gov/policy-issues/financial-markets-financial-institutions-and-fiscal-service/debt-limit

³https://www.congress.gov/bill/112th-congress/senate-bill/365/text

⁴Bloomberg

⁵Bank of America Corporate Master Bond Index Spread to Worst statistics, 6/30/2011 to 12/31/2011.

⁶https://www.irs.gov/tax-exempt-bonds/effect-of-sequestration-on-state-local-government-filers-of-form-8038-cp

⁷https://www.reuters.com/article/municipals-garvee-downgrades/moodys-downgrades-27-garvee-ratings-affects-10-bln-in-debt-idINL1E8MF09O20121115