Debt-Limit Debate Changes the Savings Game

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NEW YORK (MainStreet) — Just as Washington managed to avoid a government shutdown over the budget, we start hearing dire warnings about the tug of war over the debt limit: If it’s not raised, it will be Armageddon.

But in fact, a failure to resolve the debt-limit debate could indeed be very bad for all of us, undermining bond values, driving up borrowing costs and probably stunting the economic recovery.

In a nutshell, here’s what’s happening: The government spends more than it takes in from taxes and makes it up by borrowing, which is done by selling bonds. Every year the government sells new bonds to pay the principal due on older bonds that mature, like a consumer shifting debt from one credit card to another.

Congress makes this possible by routinely raising the debt limit, currently at $14.3 trillion. If it didn’t, something would have to give. Most likely the government would default, or stop paying interest or principal on some of the bonds it had sold in the past.

But isn’t that just a risk investors knowingly take when they buy bonds?

Technically yes, but U.S. government bonds have long been a kind of gold standard for safety, since the government, unlike corporations that issue bonds, never defaults. Because the bonds are considered safe, investors do not demand high interest earnings to compensate for risk, so the government can borrow at relatively low rates, which is good for taxpayers.

But if the risk of a government default rises, investors would demand higher yields. Currently, the 10-year Treasury bond yields about 3.6%, or $36 a year for a $1,000 bond. If newer bonds paid twice as much because of greater default risk, investors might pay only $500 for an older bond, so that $36 would equal 7.2% of the bond’s price. It’s actually a bit more complicated, but that’s generally why a rise in interest rates causes older bonds to fall in price.

If you don’t own any Treasury bonds, should you care? Well, if you have a bond mutual fund, a balanced fund, target-date fund or pension, you may own Treasury bonds without realizing it. And if you own other types of bonds, such as corporate or municipal bonds, you could be at risk because a spike in Treasury yields would lift yields of other types of bonds, causing their prices to drop as well.

And of course, higher rates would force us to pay more to borrow money for our homes or cars, to go to college or maintain a credit card balance.

Even if Republicans and Democrats can iron out their budget differences and agree on a workable debt limit, jitters could cause bond values to drop this spring. This may not be a great time to put new money into bonds of any kind, especially long-term bonds that are hit harder by rising rates.

Instead, this might be a time for keeping cash the old fashioned way, in federally insured bank savings or certificates of deposit. With the average 12-month CD paying just under 0.5%, you certainly won’t get rich on interest but your principal will be safe.

It might also be prudent to pay down any floating-rate debt, such as credit cards, or an outstanding home equity line of credit, just in case interest rates spike. If you’re thinking of borrowing – to buy a home or refinance a mortgage, for instance – consider locking in a fixed-rate loan at today’s attractive levels, rather than waiting.

After all, many experts predicted interest rates would rise even before Washington started squabbling about the debt limit.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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