The US debt ceiling will roil financial markets this month, as Republicans in Congress demand deep spending cuts before agreeing to increase the limit on federal debt.
The same thing happened in 1995, 2011, and 2013. Each time, US stocks and bonds rallied.
Expect a default to be averted at the last minute – again.
A clever way that the US Treasury can financially engineer its way out of a default if needed is by issuing “premium bonds.”
Over the next month, expect a high-profile and uniquely American political fight to make headlines – the fight over the US “debt limit.”
The US is one of only two countries in the world that has a statutorily imposed limit on its national debt. In other nations, the government produces a budget, which includes an automatic approval of any borrowing required to fund any deficit that the budget incurs. But in the US and Denmark, the legislature has to separately approve an authorization to borrow — kind of like your bank increasing a spending limit on a credit card.
The debt limit came about during World War I as a largely procedural measure to manage spending. The law that passed is called the Second Liberty Bond Act of 1917. Every year from 1917 to 1994, Congress raised the debt limit without much of a fuss, but in 1995 (and then again in 2011 and in 2013) Republicans in Congress refused to raise the debt limit as a way to force a Democratic president to reduce spending.
Should investors be worried? If the US comes close to a default on the debt, will interest rates rise and stocks fall?
Historical Experience from 1995
Consider what happened the last few times that the US debt ceiling became a political fight.
In 1995, I was an intern for the Republicans on the House Budget Committee during the 104th Congress, so I remember how this played out vividly. Bill Clinton was president and his Democratic Party had held a solid majority in Congress. Dems held between 256 and 258 seats in the House (against 176 or 177 for the GOP) after the 1992 elections, and as many as 58 of the 100 Senate seats. In those two years of a “unified government,” the federal deficit ran between 3.7% and 4.4% of GDP.
Republicans were then swept into power in November 1994 for the first time since 1954, with a net gain of 54 seats in the House and 9 seats in the Senate. The new House leader was Newt Gingrich; he had pledged a “Contract with America” about 6 weeks before the election. This document became the central campaign platform and effectively nationalized the normally hyper-local midterm Congressional election.
The Contract with America made several pledges:
Auditing Congressional spending for waste, fraud, and abuse
A balanced budget amendment
Requiring a three-fifths “super-majority” vote to pass any tax increase
Term limits on all committee chairs
Republicans not only threatened President Clinton with the debt ceiling, but they actually shut down the government for 6 days in November and 21 more days in December to force the Clinton administration to accept budget cuts. In the end, the US government didn’t default. Clinton was helped by the polls running in his favor, made some budget concessions, and signed off on a budget that reduced the deficit to 1% of GDP in 1996 and then was balanced in 1998, 1999, and 2000.
As politics played out over the winter of 1994 and into 1995, there was much discussion about a possible default by the United States Treasury. Despite that speculation, here is how the markets in the US performed. The stock market rose by about 40% between the date of the Republican electoral landslide and the eventual debt limit agreement in March 1996. Treasury yields remained in a range between 6.0% and 6.5% throughout the whole shutdown, never really pricing in a realistic possibility of a default.
It might seem counterintuitive that yields fell and stocks rallied during (and after) a government shutdown. Obviously, the market never really took the threat of a default seriously, and it actually welcomed a conversation about fiscal discipline. The market correctly anticipated a resolution that included lower deficits and more effective government spending.
US Debt Downgrade in 2011
Democrats enjoyed two years of unified government from 2008–2010. They also had a supermajority in the Senate (meaning that they had enough votes to pass legislation and to override any filibusters), so they had free rein to implement their legislative priorities.
This was in the aftermath of the 2008-2009 Great Financial Crisis and the government ran two years of deficits at around 9% of GDP – a US peacetime record at the time. President Barack Obama’s top legislative priority in those two years was the hugely unpopular Affordable Care Act, which resulted in a mid-term drubbing of the Democrats, as well the gargantuan fiscal deficit and ensuing shaky economic recovery from the deep 2008-2009 recession.
In November 2010, Republicans won a net gain of 63 seats in the House, the largest shift in seats since the 1948 elections. In state elections, Republicans won a net gain of six gubernatorial seats and flipped control of 20 state legislative chambers, giving them a substantial advantage in the redistricting that occurred following the 2010 United States Census. They also netted six Senate seats, though Democrats retained a 51–47 majority, plus two independents caucused and voted with the Democrats. (Democrats went on to lose the Senate in 2014.)
Republicans demanded that President Obama negotiate over deficit reduction in exchange for an increase in the debt ceiling. On July 31, two days prior to when the Treasury estimated the borrowing authority of the United States would be exhausted, Republicans agreed to raise the debt ceiling in exchange for a complex deal of significant future spending cuts.
The budget stand-off looked so grim while it was happening that it actually resulted in a ratings agency review. S&P announced a negative outlook on the AAA rating of US Treasury debt in April 2011 for the first time in US history. On August 5, 2011, they downgraded US Treasuries from AAA to AA+. The announcement came three days after an agreement to increase the debt ceiling by means of the Budget Control Act of 2011 on August 2, 2011.
The impact again on US financial markets was actually positive. The stock market had a volatile week in early August, but Treasury rates declined throughout and the equity markets eventually continued a sharp rally that had begun with the Republican landslide.
US Debt Crisis in 2013
The détente between Republicans and Democrats didn’t last long – in fact, it only lasted until the next time that the debt limit came up for a vote. The budget battle began anew in January 2013, when the United States reached the debt ceiling of $16.394T that had been enacted following the 2011 increase. The US Treasury began taking extraordinary measures to enable payments and stated that it would delay payments if funds could not be raised through extraordinary measures.
The crisis ended on October 17, 2013 with the passing of the Continuing Appropriations Act, 2014 – although debate continues about the appropriate level of government spending and use of the debt ceiling in such negotiations.
Again, the figure below shows how US financial markets reacted — an almost continuous rise in the stock market along with steady or even declining 10-year Treasury yields.
How “Premium Bonds” Can Save the Day
Finally, here is one more reason not to worry about the debt ceiling.
As an alternative to an outright default, the US has several options by which it can manage the amount of debt outstanding.
First, the US Congress can simply pass a re-authorized budget where tax receipts offset spending and thus adds no more to the national debt. This would probably require a 25-30% reduction in total spending (maybe offset by some tax increases) for a few months while budget negotiations play out. As an alternative to an outright default, a re-authorized budget seems like it should be an easy vote for Congress.
What Are Premium and Discount Bonds?
Second, the Treasury could also financially engineer their way out of the debt limit problem by issuing something called premium bonds. This is an ultra-sneaky way to game the system, so it takes a bit of explaining…
Typically, when the government spends more money than it raises in taxes, it runs a fiscal deficit and has to borrow the difference. To borrow, the Department of Treasury issues Treasury Securities. These securities come in a few different forms:
Treasury Bonds – maturities of 20+ years
Treasury Notes – maturities of 2-20 years
Treasury Bills – maturities of 1 year or less
These Treasury instruments have a coupon, which is typically a payment every six months, and a face value that pays off at maturity.
Normally, the face value is $1,000 and the coupon is set to something very close to the present yield to maturity that the market assigns to bonds of similar maturity that are trading on the open market. The yield to maturity is basically the rate return that investors are requiring in order to invest in a bond.
The Treasury then conducts an auction in which investors set the coupon rate in exchange for the Treasury security. Let’s take an example. Imagine that the Treasury wants to issue a Treasury note maturing in 10 years. Today, that note would have a yield of about 3.45%, which is the prevailing market-clearing interest rate on 10-year Treasuries. The Treasury might set the coupon for new issuance right at $34.50, paid in two semi-annual installments (of $17.25) for a Treasury note maturing on April 30, 2033. The coupon rate on this bond (the annual coupon divided by the principal) is 3.45%.
On its first day of trading, the market value of the bond – or its price – will be very close to $1,000, which is the face value of the bond. In the lingo of bond traders, this bond’s price will be very close to par.
As a matter of national debt accounting, the Treasury has just added $1,000 – the “face value” of the Treasury – to the federal debt.
So far, so good.
Now, these bonds will start trading in the secondary market. Over time, yields (otherwise known as interest rates) will go up or go down. For any existing bond, the coupon has been fixed at the time of original issuance, so it can’t go up or down. Instead, the market price will adjust to reflect prevailing interest rates.
If interest rates head lower — say to 2.45% — then new bonds coming out of the Treasury will carry a principal value of $24.50 and a face value of $1,000. Therefore, an old bond with a principal value of $1,000 and a semi-annual coupon of $34.50 is pretty valuable, and the price of that bond will go up to about $1,088.22.
If the market price of a bond exceeds its face value (i.e., it trades above par), it’s called a premium bond.
On the other hand, if interest rates head higher, say to 5.5%. If that happens, a bond with a coupon rate of only 3.45% isn’t so valuable. The market price would have to drop to about $843.92 in order to make it financially competitive.
As the price of the bond falls below the face value (i.e., it trades below par), it becomes a discount bond.
In summary, a bond starts its life with a face value and a coupon, and an interest rate is determined at an initial auction. The price of the bond floats over time.
Even though the market value of the Treasury changes, the impact to the official federal debt does not change. As a matter of accounting, the Treasury note adds the face value of $1,000 to the amount of debt while the note is outstanding. Upon being redeemed by the Treasury at maturity, the federal debt will reduce by $1,000.
The Treasury Has Previously Issued Zero-Coupon Bonds
What I have described above is just a market convention. There is no law that says that the Treasury must issue bonds, with coupons set at (roughly) the prevailing yield to maturity.
As a matter of fact, a few years ago the Treasury began issuing something called zero-coupon bonds, which are bonds that do not pay any interest during the life of the bonds. Instead, investors buy zero-coupon bonds at a deep discount from their face value, which is the amount the investor will receive when the bond comes due.
For example, the investor might pay $3,500 to purchase a 20-year zero-coupon bond with a face value of $10,000. After 20 years, the issuer of the bond pays you $10,000. The yield works out to about 5.4%, compounded annually.
Because zero-coupon bonds pay no interest until maturity, their prices fluctuate more than other types of bonds in the secondary market. But it just goes to prove the point that the Treasury can already deviate from the market convention of issuing bonds at par.
What Happens to the Federal Debt If Treasury Issues High-Coupon, Premium Bonds?
Well, what if the government issues a premium bond instead of a discount bond (like the zero-coupon bond)? For instance, the government could say, “I’m going to issue a 10-year bond, with a face value of $1,000 and with a coupon of $500, paid every year.”
This coupon rate would be 50%, which would be very valuable to investors. In fact, the market price of this premium bond would probably be around $4,388, even though the face value was just $1,000.
It turns out that the Treasury could raise $4,388 in real money in exchange for issuing a bond with a face value of only $1,000. And here’s the clever bit: it would only add $1,000 to the federal debt.
(If you followed the recent bankruptcy of Silicon Valley Bank, you are already familiar with this accounting convention. Banks are supposed to hold any Treasury investments in a “held to maturity” category at their cost, not at constantly fluctuating market prices.)
So this is the way to game the system. The government can raise a large sum of money and not increase the amount of debt outstanding with these two simple steps:
Selling low face-value bonds with high coupon rates to raise money
Then using proceeds to refinance older bonds with large face values and lower coupon rates
The Treasury can still pay its bills, while lowering the total amount of Treasury debt outstanding and complying with the Second Liberty Bond Act of 1917.
Would this actually work?
Well, the situation probably isn’t ideal for properly functioning capital markets. But I’m pretty certain that it’s legal and would be effective. It would allow the US to put off a default, which would certainly result in a lot of bad things happening, including the following:
Higher yields on US Treasury debt, which would increase the government’s cost of funds and the federal deficit
Higher borrowing costs for quasi-governmental entities like Freddie Mac and Fannie Mae, where the federal government is the guarantor on the debt
A ripple effect throughout all debt markets, which typically price in relation to US Treasuries
Technically, the Treasury can do these two simple steps with low face-value bonds and refinancing older bonds unless Republicans pass a law to prevent this manipulation. But Republicans only control the House, and by a narrow majority, while the Democrats have the Senate. Any legislation to constrain Treasury borrowing would have to pass both chambers of Congress.
Aman was the COO of 500 Startups, has been the CFO of Sonos, and led finance at PayPal. Before that, Aman worked at Lehman Brothers and McKinsey, majored in economics at Stanford, and earned a law degree from Harvard, so he is particularly good at dollar signs and clauses and commas.
Aman has more than 15 years of financial and operational experience from both private and public technology companies. He has been a member of the management teams at some of the most successful companies in the world, including PayPal, eBay, and Sonos.
Prior to PVC, Aman was the COOof 500 Startups, which during his tenure was the world’s most active VC firm, measured by the number of investments made. Aman managed 500’s global fundraising team, the seed accelerator team, and the Series A growth programs. He also managed the Investment Committee for the firm’s global funds ($500MAUM).
Aman led the strategy teams at both PayPal and eBay Marketplaces and served as the divisional CFO of eBay’s North American Marketplace business, which generated over $2B in revenues and nearly $1B in operating profit.
As CFO, Aman has guided his companies to over $1B in debt and equity financings from family offices, HNWIs, VC/PE funds, banks, and public markets.
CFA since 2000
Financial Analyst at Lehman Brothers, Associate at McKinsey
Taught Economics at Harvard University
JD, Harvard Law School
BA, Economics and Public Policy, Stanford University
PayPal Mafia: wrote the first draft of PayPal's S-1 in the winter of 2000.
CFO at two different unicorns: Sonos, Inc. (NASDAQ: SONO) and CAN Capital