Debt ceiling: A CIO's perspective

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Debt ceiling: A CIO's perspective

Expert Perspective


May 24, 2023

As Congress and the White House continue to negotiate on raising the debt ceiling, investors are asking how they should respond if lawmakers fail to reach a deal. It's best to stay the course by maintaining a long-term perspective and sticking with the agreed-upon investment plan.

A potential default's impact on markets and the economy

The most obvious impact of a failure to agree on raising the debt limit is that it could lead to a default. This would happen if the U.S. Treasury delayed interest or principal payments on Treasury securities. A technical default would occur if the Treasury failed to make payments when due on its non-interest obligations, such as to government contractors or to recipients of entitlements such as Social Security. A default would be unprecedented and would likely have significant global market and economic repercussions. The greatest one would be damage to U.S. credibility. We caught a glimpse of this in 2011 during a previous debt ceiling debate when Standard and Poor's, a major ratings agency, downgraded its U.S. credit rating, citing among other things a diminished "predictability of American policymaking."

But should the United States default, it would no longer be able to fully reap the benefits—notably, financing on the best possible terms—bestowed on the most reliable debtors. The government's own financing costs, borne by taxpayers, could increase. And since broader borrowing costs are pegged to Treasuries, interest rates would likely also rise for businesses, homeowners, and consumers.

Stocks would probably be pressured as higher rates made companies' future cash flows less predictable. Spillover effects to global markets and economies would be likely. Such developments occurring at a time when global recessionary risks are already increasing make averting such a scenario even more important.

To be clear, we don't doubt for a minute the government's ultimate ability to pay its obligations. Our assessment of the minimal credit risk posed by the United States is supported by its strong economic fundamentals, excellent market access and financing flexibility, and favorable long-term prospects, along with the dollar's status as a global reserve currency.

How should investors prepare for a potential U.S. debt default?

Investors should be prepared for potentially significant market volatility, both as the deadline for Congress to raise the debt limit approaches and in the event of a default. They should have a plan they can stick with for the long term. Maintaining discipline can be challenging during extended periods of volatility, but that's when it's most important. Investors should consider how they might respond in the face of a market event that could cause their investments to drop in value, making sure they have the appropriate liquidity they might need to avoid having to sell securities. Such a gut check is meant to ward off any inclination to panic and sell, potentially at market lows, in such circumstances.

Having the discipline to stick to a well-considered investment plan is a hallmark of Vanguard's principles for investing success. These principles can be especially useful in times of uncertainty such as this. While it is important to stay abreast of current events, we believe investors should focus on what they can control:

  • Have clear, appropriate goals.
  • Have an appropriate mix of assets to achieve those goals.
  • Keep investing costs low.
  • Maintain discipline in a well-considered investment plan.

Guide clients confidently

Now's the time to coach your clients through uncertainty—precisely when they need you the most—and we have tools to help. Our behavioral coaching toolkit includes the Market Hindsight Tool, which simulates market performance for landmark historical events, specifically highlighting comparative results for staying the course versus selling to cash.


Hear more from Vanguard leaders

In this short audiocast, Greg Davis, Vanguard's chief investment officer, and Sara Devereux, the global head of fixed income, discuss the likelihood of a default, the potential ramifications on the financial markets and the economy, and what precautions Vanguard has taken to mitigate the risk in our portfolios.

Greg Davis: I'm Greg Davis, chief investment officer at Vanguard. With me today is Sara Devereux, the global head of our fixed income group. Well, Sara, June is just around the corner, so guess what we'll be discussing today—the U.S. debt limit.

Sara Devereux: Yes, it's top of mind for many investors and certainly all professional money managers, particularly those of us in fixed income. Treasury Secretary Janet Yellen said that it's possible the U.S. government may default on its debt as early as June 1. But really, we've been working on this for a while. Since January, we've been taking precautionary steps in our portfolios in case that actually did happen.

Greg Davis: So, before we go there, it might benefit some of our listeners for us just to take a step back and talk broadly about the debt ceiling and the possibility and potential ramifications of a debt default. As we're talking now, we know that Congress and the White House are still debating the policy changes that would accompany a debt ceiling increase and ultimately how long that increase could last.

Normally, we know that this is a routine affair with Congress raising the debt limit to pay off obligations that were previously approved by Congress. It's really not an authorization for future spending. We know that Congress has raised the debt limit multiple times, dozens of times, over the past century under both Democratic and Republican administrations. The closest thing that we've come to a debt default was back in 2011, when they raised the debt limit just days before exhausting all of the Treasury's cash reserves.

Sara Devereux: Oh, yes. And that incident resulted in Standard and Poor's downgrading the federal government's credit rating. That was inconceivable until then.

Greg Davis: So, Sara, what's your assessment of a possible debt default now?

Sara Devereux: Well, collectively, we still believe that a debt default is unlikely. It would be truly unprecedented with far-reaching ramifications.

Greg Davis: And what are those ramifications for our fixed income investors?

Sara Devereux: Well, first, a caveat. Since a default would be unprecedented, no one really knows for sure exactly what all of the consequences would be. Obviously, there will be volatility in the markets even before the default itself, as the markets price in for an anticipated future.

Treasuries and government agency bonds are by far the largest share of the U.S. taxable bond market. But you don't have to be invested in Treasuries to feel the impact, because the impact of a default would be felt across the entire global economy. Treasuries are widely held by foreign governments and parties, so it has implications on currencies, trade balances, and prices of goods and services. Also, borrowing costs are pegged to Treasuries, so it has an impact not just for the government, but also for businesses, homeowners, and consumers.

I should add that even if there is a default, we expect Congress will eventually raise the debt limit and the U.S. will resume paying its obligations. The real question is whether there is long-term damage. Will the phrase "the full faith and credit of the United States" still hold as much weight in the future? Or will higher rates be a permanent fixture from now on?

Greg Davis: So, you have risk at the macroeconomic level, as well as within fixed income. What have we been doing to reduce the risk within our portfolios?

Sara Devereux: Well, we've been taking a number of steps within our bond and money market funds, such as not investing in Treasuries where the maturity dates fall in the potential default window whenever we can avoid it.

Since the government will ultimately make good on its debt, managing the risk of default is largely an operational exercise in timing cash flows. We at Vanguard are mitigating that risk for investors so they can tune out the noise and stay focused on the long term.

That said, there will be volatility, and no one can totally escape that, which is true for all asset managers, not just Vanguard.

Now, Greg, let me turn the table on you. What are the ramifications for the equity markets?

Greg Davis: It's a great question, Sara. I mean, some of the same macro factors that you mentioned earlier would clearly have an impact on the equity markets as well. When you think about a slowing economy, lower consumer and business spending, you couple that with greater uncertainty in general may cause investors to ultimately pull back from stocks just like they did back in 2011. And again, that was a period where we were very close to a debt default as well. So, unless there's really a quick resolution, we'll likely see volatility on the equity side as well.

Sara Devereux: You've been at Vanguard for almost 24 years now, so you are no stranger to periods of volatility.

Greg Davis: Yeah, unfortunately, we've seen volatility many times before. Although an actual debt default would be very unique and, hopefully, we don't go there.

The message we're giving to our investors has been consistent because it stands the test of time: If you're already well diversified in an allocation that suits your goals, your time horizon, and your risk tolerance, then of course, stay the course.

That includes maintaining the appropriate level of cash reserves, which will help prevent needing to sell securities in a potential down market. But the other thing we want people to remember is that volatility goes both ways—up and down. Time in the markets is better than trying to time the markets. So that's our thoughts.

Sara Devereux: That's so true. Thanks, Greg.

Greg Davis: Thank you, Sara. And for our listeners, as the situation in D.C. continues to develop, please stay tuned to our digital channels for updates and thoughts from other Vanguard leaders. Until then, take care.


All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Investments in bonds are subject to interest rate, credit, and inflation risk.

While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.


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