The Debt Ceiling: What if the Worst Happens

The story that dominates the headlines these days is the debt ceiling.  As negotiations in Congress go on, fear that a compromise may not be reached grows, despite the fact that most analysts are confident that an agreement will be reached by the August 2nd deadline.  The common belief is that none of our politicians want to be responsible for derailing our economy.  Despite these thoughts, the stock market has recently sold off and investors are concerned.

What is important to remember is that the U.S. does not have an issue paying its creditors.  The real issue is that there is a fundamental debate on how to tax and spend.  Some of our country’s leaders have decided that this is an excellent occasion to bring the debate to the forefront.  Other countries like Greece and Ireland are in a different scenario: they do not have the means to pay their creditors and will likely default on their obligations, even with restructuring and assistance.

What if our politicians can’t agree and the U.S. does default on its obligations? This is a doomsday scenario.  The first thing that would happen is that the bond market would go into a tailspin.  The US debt market has long been considered the safest investment in the world.  Creditors have always received full payment of their investment.  The US has never defaulted.  A default would signal to investors that lending to the US government is no longer a guaranteed return or a risk free investment.  Confidence in the U.S. Treasury would similarly falter, causing future borrowing to become much more expensive.  Interest rates would rise as prices fall.

If you are of the opinion that the US will likely default on its debt, a cheap way to take advantage of this scenario would be to purchase a put spread in the 30 year bond.  One idea is to purchase the September T-bond 125 put and sell the 120 put.  The trade costs about $812.50 (plus commissions) and the maximum profit is $4,187.50 (minus commissions).  The maximum loss is the cost of the spread, $812.50.

A default is a nuclear option and a worst case scenario.  It is unlikely to occur and it would be devastating to the U.S. economy.  However, using the puts in the 30 year Treasury bond could be an excellent way to take advantage of a bad situation.