If the US Congress doesn’t take action to raise the debt ceiling before it is reached, which may happen as soon as June 1, the U.S. Treasury Department is in danger of defaulting on its debt. That creates questions for holders of Treasury bills, notes, and bonds about whether their holdings would be impacted and what will happen if the debt is not repaid or an interest payment is missed.

Here are six important things to think about.

If one payment is missed, does the entire bond default?

No. Because Treasuries lack cross default clauses, a missed payment on one issue may not necessarily have an effect on others.

The U.S. Treasury Department is believed to be most likely to run out of funds in early June, and swings in the Treasury bill market thus far reflect localised worry about specific securities that mature at that time. These notes’ yields are trading at greater rates than similar debt with a later maturity date.

Will Trading on Defaulted Issues Stop?

According to analysts, it is essential that Treasuries can still be transferred via the Fedwire Securities Service, the settlement system of the Federal Reserve. By announcing a payment delay the day before, the Treasury can assure the assets stay on Fedwire. Until it can make the payment, it should do this every day.

Will Debt Holders Receive Payment Delay Compensation?

Analysts anticipate that the holders of the debt will be compensated for the delay, but it is unclear exactly how this will transpire. According to JPMorgan, this would probably take the shape of a variable rate on late bill or coupon payments.

However, according to the Treasury Market Practises Group, “it would require explicit legislation by Congress to provide compensation to holders of securities subject to a delayed payment on Treasury debt for the delay in these payments.”

Due to technological issues, the Treasury delayed redeeming some Treasury bills in 1979. Investors were compensated for the delay if they failed to get their interest or principal cheques.

Treasury can extend maturing debt.

Yes. As long as it makes the coupon payment due on the same day, Treasury can roll over maturing coupon securities on the maturity date without affecting its current debt or remaining cash balance, according to JPMorgan.

Because they are sold at a discount and later returned at par, treasury bills are more sophisticated. However, some analysts point out that the Treasury would be more likely to postpone auctions and cancel debt payments once it reaches its debt ceiling since it must pay multiple bills on top of its debt obligations.

The Treasury revealed plans to introduce 161-day cash management bills, four-week and eight-week notes on Thursday. Other auctions that are anticipated to include other bill maturities in early June have not yet been announced.

Ratings downgrades could result in forced sales

Ratings downgrades may affect demand because many bond holders, especially money market fund investors, only purchase very highly rated debt. However, there are restrictions that might prevent widespread forced selling.

JPMorgan points out that money fund rules and regulations do not mandate quick liquidation upon default, and that boards of directors of funds probably have the authority to decide whether to hold or sell. Few of these would probably decide to market distressed defaulted securities.

Repurchase agreements backed by Treasury securities are another investment option for money market funds. However, the use of short-term debt as collateral is uncommon. It may be necessary to replace longer-dated debt with coupon payments due during the risk period in order to avoid higher haircuts, which are deducted from the assets’ values.

Would Treasury Collateral Be Affected by a Default? Within Clearing Houses

Trillions of dollars’ worth of derivatives are backed by Treasuries at clearing houses. Similar to repos, short-term debt is typically not accepted as collateral for these deals, but any Treasury securities with coupons that are at risk of not being repaid may be subject to greater haircuts or require replacement. The need for more margin could potentially rise as a result of increased market volatility brought on by any default. 

(Adapted from Reuters.com)

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