The federal government is allowed to borrow money to spend on things like Social Security, Medicare, defense programs, etc. The catch is, there’s a limit to how much the government can borrow, and that limit is called the debt ceiling. Congress authorizes how much debt the federal government can take on. If the government is going to exceed this limit, then Congress must approve raising the debt ceiling.

If you’ve been following the news, you may have heard that the debt ceiling (currently around $31.4 trillion) has already been reached. As we wait and see how Congress will respond, here’s a look at why the debt ceiling is important and how it can impact investors.

Where Does National Debt Come From?

As a taxpayer, you may be confused as to why national debt exists if taxes are collected to cover costs associated with running the government. Almost every year, the government actually spends more than it collects in taxes, which creates a deficit. That means the government must borrow money to fill the gap, which accumulates over time to create national debt.

There are certain programs, like Social Security and Medicare, that are considered “mandatory spending” and make up the majority of the federal government’s budget. The rest is called “discretionary spending,” which Congress can choose to spend on other programs, infrastructure updates, wars, or national crises like the Covid-19 pandemic.

How Is the National Debt Financed?

When the federal government must take on more debt, it sells bonds backed by the U.S. Treasury. Individual investors like you can buy bonds, and other countries can own U.S. debt as well. In fact, about a third of all public debt is owned by foreign nations like Japan and China.¹

What Happens to Bondholders if the Government Defaults?

One of the reasons why government bonds are considered the “safest” investment option is because of the incredibly low possibility that the U.S. government will default on its loan. But still, when the debt ceiling comes into question, it’s natural for anyone who holds Treasury bonds to consider the possibility of losing money.

It’s helpful to note that the government has never defaulted on its debt, meaning the debt ceiling has never not been raised. Although, the government did come close to defaulting in 2011 and 2013 because Congress did not raise the debt ceiling in time.

However, the Federal Reserve and U.S. Treasury did prioritize paying back bondholders during these periods. If you or someone you know worked for the federal government at the time, you may remember that all federal employees were furloughed during this period. That’s because the government had to make a choice, and neglecting to pay its creditors could lead to long-term economic turmoil.

With coming this close to defaulting on its debts, credit rating agencies actually downgraded the U.S. from its AAA credit rating (the highest rating possible) to an AA+ rating. Even this small change had investors spooked, which sent the market into a temporary tailspin.

As we look ahead, Congress will once again need to prioritize payments if the debt ceiling isn’t raised in time. Based on how this scenario has played out in the past, it’s likely paying back bondholders will be high on the list.

Should Investors Worry About the Debt Ceiling?

The short answer is “no,” despite political and media pundits bringing attention to it. 

The “X date,” or date on which the government would technically default if extraordinary measures aren’t taken, is expected to be around early Fall 2023. Congress has a longstanding history of waiting until the eleventh hour to take action, meaning we’re unlikely to see anything get resolved until closer to that date.

As the X date approaches, our team will keep a close eye on the markets. In the past, investors became spooked by the looming possibility of a default and upset the markets as a result.

In fact, in 2011 the S&P 500 dropped 17.2% in the month leading up to the X date. While it can certainly cause some stress to watch your portfolio drop value so suddenly, it’s more important to consider how the markets recovered. Over the following 12 months, the S&P rose 28.1%, making this a prime example of why it’s rewarding to be a patient investor.² Pulling out your money at the first sign of trouble can lock in losses and cause your portfolio’s long-term performance to suffer.

Over the coming months, you’ll likely hear more and more speculation or “solutions” from members on both sides of the political spectrum. For now, it’s best to try to tune out the noise and remain focused on your personal long-term goals. If there are adjustments that need to be made to your portfolio, that’s something we can evaluate together. Feel free to put some time on the calendar to discuss any concerns you may have about your portfolio.

^Sources:

^{1 https://www.npr.org/2023/03/23/1163448930/what-is-the-debt-ceiling-explanation}

^{2 https://www.reuters.com/markets/us/us-debt-ceiling-markets-gauging-fallout-2023-02-16/}