Allspring's Global Liquidity Solutions Team recently refreshed the publication, "The Debt Ceiling - Frequently Asked Questions." The piece states, "We preface our discussion of the debt ceiling with the belief that the likelihood of one or multiple technical defaults due to a protracted debt ceiling debate is remote. In the unlikely event of a technical default, we believe it will be short-lived and that, upon resolution, funds are likely to be unaffected. We further believe that, given evidence of preplanning, the Federal Reserve (Fed) would be prepared to act if necessary to calm government markets and ensure their smooth and orderly functioning. While no one knows what a government default situation would look like, we can offer opinions based on our research." (Note: Thanks once more to those who attended our Money Fund Symposium in Boston last week! Attendees and Crane Data Subscribers may access the recordings and MFS Conference Materials here.)
It explains, "Past experience demonstrates that, when push comes to shove, legislators raise the debt ceiling in order to avoid a default. It has not mattered how cordial or fractious the relations have been between the two parties in Congress or between the legislative and executive branches. While some debt ceiling episodes have gone smoothly and others have been used to try to gain a political advantage, eventually a resolution has been reached."
Allspring's "Frequently asked questions include: "Are the debt limit and a government shutdown the same thing?" They reply, "The debt limit and a government shutdown are completely unrelated. A partial government shutdown relates to the budget process and occurs when Congress fails to appropriate funds for operating the government, while the debt limit only constrains the government's total indebtedness. It's entirely possible to have a budget dispute resulting in a government shutdown when the debt ceiling is suspended or far from binding, just as it's possible to have debt ceiling issues in a fully appropriated government with no threat of a shutdown."
Allspring queries, "What impact, if any, does a prolonged debate on raising the limit have on the money markets?" They comment, "Prior to the debt ceiling suspension era, the money markets reacted to the debt ceiling once per episode -- when the debt outstanding approached the limit, cash approached zero, and extraordinary measures approached exhaustion. Leading up to that time, the Treasury typically reduced Treasury bill (T-bill) issuance, resulting in a relative shortage of T-bills, driving their yields lower. At the same time, as the market assessed the likelihood of nonpayment on particular Treasury securities, those instruments generally sold off."
The brief continues, "The specific securities deemed at risk were generally T-bills maturing in the several weeks after the drop-dead date, as well as Treasury notes and bonds -- both those maturing in the same time period and those with interest payments due in that window. For example, if a payment late in October was considered questionable, investors might shun not only Treasury notes maturing then but also those maturing in April or October of future years, which would be due to receive interest payments that might be compromised. The rates on other money market instruments, including government-sponsored enterprise (GSE) discount notes, were generally little changed, as they would be unaffected by a payment delay on Treasury securities."
Allspring asks, "If the debt limit is not raised or suspended and all extraordinary measures have been exhausted by the Treasury, will the U.S. government default?" They answer, "If we get to the point that the Treasury has exhausted all extraordinary measures, explored any further measures, and simply run out of cash to pay the government's bills, then it is likely it would have to default. But what is meant by 'default'? The most likely answer is that it would mean a temporary delay in payments that come due -- in this case, the payment of maturities and interest on Treasury securities. This is widely termed a technical default. The bottom line is that we have no reason to expect the government will default on its obligations in the traditional sense. The worst-case scenario is that it may have to delay a payment or two for a very short period, but the payment likely will be made."
The article also questions, "What would a default look like?" They respond, "Answers to this question fall in the realm of pure speculation because we have very little concrete evidence upon which to base our opinions. Based on past experience, when push comes to shove, legislators act as quickly as possible to raise or suspend the debt ceiling to allow the government to get back to business. `For this reason, we think that, in the unlikely event the government does go into technical default (that is, delaying payment on maturing securities), it would be for a very short period, affecting at most one or two payments. Neither side of the aisle wants to be the one that caused a government default."
The Q&A says, "From a market perspective, we can only speculate. During previous crises, securities that matured shortly after the drop-dead date experienced some stress, with investors by and large shunning their purchase and risk premia causing yields on those bills to gap out. Longer bills, however, were largely unaffected, and trading in those securities continued without discernible disruption. Under a default scenario, depending on whether the securities in question remain on the Fedwire (and we think that will be the case), we could see something similar happen."
It adds, "How would a default affect the repo market? From an operational standpoint, defaulted Treasury securities, the specific issues that had suffered missed or delayed payments, would still be eligible for inclusion as collateral in repo transactions so long as they remained in Fedwire. As a practical matter, lenders might be reluctant to accept such tainted securities as collateral unless higher haircuts, or margins, were offered. In addition, it's possible that lenders also could refuse to accept Treasury securities at risk of default as collateral, even if the Treasury had not yet missed a payment on any security. Because there is no cross-default provision for Treasury securities, the vast majority of Treasury securities could continue to be used to collateralize repo transactions, at least operationally."
Finally, they ask, "If the U.S. government were to default, would money market funds be required to sell any of their defaulted securities holdings?" Allspring answers, "Not necessarily. Under SEC Rule 2a-7, a fund is not automatically required to dispose of a security that is in default. A fund may continue to hold a defaulted security if the fund's board of trustees deems it would be in the best interest of the fund's shareholders.... [A] board may find it is not in the best interests of the fund or its shareholders to sell a delayed security, especially if such a forced sale would lead to a trading loss for the fund and adversely affect the fund's net asset value."
