USFR - TBIL: How Will Debt Ceiling Impact Treasury Bills?

2023-04-27 08:59:16 ET

Summary

• TBIL ETF provides investment returns of owning 3-month treasury bills.
• A debt ceiling standoff threatens to inject credit risk into riskless treasury securities.
• While I believe the risk of a U.S. default is very remote, there is a real risk of principal repayment delay on TBIL's treasury bill holdings as they mature.
• To mitigate this risk, I recommend investors look at the USFR, which is functionally equivalent but owns floating-rate treasury notes with maturities in 2024 and 2025.

A reader recently asked how will the US Treasury 3 Month Bill ETF ( TBIL ) handle a potential U.S. government default and this spurred me to do a bit of thinking, as I have significant amounts of my net worth invested in the TBIL ETF.

Debt Ceiling Debate Background

First, a bit of background for those not familiar. The debt limit is the total amount of debt the U.S. Treasury is authorized to borrow to meet the government's various obligations including funding Social Security, Medicare, the military budget, and interest on the national debt.

Every few years, political disputes arise when the U.S. debt ceiling is about to be reached and politicians seize on the opportunity to instill chaos for political gains. To my knowledge, the United States of America is the only country in the world where this madness is tolerated, and even encouraged by some.

This debt-ceiling grandstanding has happened before. In 2011, the U.S. nearly defaulted on public debts as Republicans used the debt ceiling crisis to force then President Obama to negotiate on deficit reduction in exchange for raising the debt ceiling. The government was literally days away from shutting down before President Obama and Republicans agreed to a series of future budget cuts. The 2011 episode caused the first debt downgrade in the U.S. government's history.

Another debt ceiling crisis arose in early 2013, and President Obama had to sign the No Budget, No Pay Act of 2013 which suspended the debt ceiling until May 19, 2013 and restricted congressional salaries. Ultimately, the crisis dragged on for 5 months until once again, the U.S. Treasury was on the verge of default.

If the U.S. government were to ever default on its debts, the results would be catastrophic . The government would be immediately impaired from providing basic services to millions of Americans (Figure 1). Many people could literally starve without payouts from the government.

In financial markets, an asset (U.S. government treasuries) long considered the global standard for 'risk free asset' will suddenly be injected with credit risk. A default may create ripple effects throughout the financial system that are not yet known. For example, many payment systems may not even be able to handle defaulted treasuries, as that idea is so inconceivable. The U.S. dollar's reputation as the world's reserve currency will be further tarnished.

Relevance To TBIL

The reason the debt ceiling is relevant for the TBIL ETF is because the TBIL ETF holds only 3-month treasury bills in its portfolio (Figure 2).

Normally, 3 month treasury bills are the safest securities one can hold as they have virtually no interest rate risk (interest resets every 3 months) and their credit risk is considered nil due to the backing of the U.S. government. However, in recent weeks, as the debt ceiling debate intensified, we have seen confidence in the U.S. government's credit rating erode.

For example, a 1-Yr Credit Default Swap ("CDS") on the United States, a financial instrument used to hedge and bet on the creditworthiness of issuers, recently spiked to over 150 bps (Figure 3).

In fact, current US CDS levels are the highest ever, even higher than during the original 2011 debt-ceiling crisis and the 2009 Great Financial Crisis (Figure 4).

Note the CDS quoted in Figure 4 is not quite the same as the one shown in Figure 3, as one is in USD and one is in EUR. A sovereign issuer is considered less 'risky' in its own currency, as it can always print more money to satisfy its debt obligations. The 1Yr CDS in USD is currently at 76 bps .

Should TBIL Holders Be Worried?

Due to the 'end of the world' level of financial turmoil that an actual U.S. debt default will cause, I am 99.99% certain that the rational adults will prevail and the U.S. government will not default (the 0.01% chance is to account for potential political mistakes).

However, it is also looking increasingly likely that politicians will once again push the crisis until the absolute last minute before agreeing to kick the can down the road.

Technically, the U.S. reached its debt ceiling limit on January 19th, 2023 and so far, the Treasury department has been relying on extraordinary measures such as delaying payments to pension plans and using existing cash balances to stave off default.

While estimates for the 'X-date' varies, analysts widely expect the Treasury to run out of money sometime in August . However, in recent days, that estimate has been pulled forward to as soon as July, due to weak tax receipts.

Referring back to Figure 2, we can see that TBIL's portfolio holds 3-month treasury bills that mature in late-June to mid-July. Therefore, there is a real risk that the treasury bills owned by TBIL could mature in some sort of 'technical default' where there is a delay in the principal repayment due to the debt ceiling crisis.

In fact, one recent WSJ article suggests the debt ceiling standoff may be warping treasury bill rates, with the divergence between the 1-month rate and 3-month rate being the widest on record, as money market investors have a strong preference to own bills that mature before the 'X-date'.

For investors worried about this principal repayment risk, they may want to consider switching out of the TBIL ETF and into funds that hold treasury investments maturing beyond this 'X-date' window, where presumably the debt ceiling crisis will have resolved.

Alternatively, they may want to consider the WisdomTree Floating Rate Treasury Fund ( USFR ), which holds floating rate treasuries that are functionally similar to 3-month treasury bills with interest rates that reset quarterly, but with principal maturity dates in 2024 and 2025 (Figure 5). I wrote about the USFR ETF here .

Conclusion

With the debt ceiling standoff between the Biden administration and Republicans threatening to jeopardize the creditworthiness of U.S. treasuries, there is a risk repayment delay on TBIL's 3-month treasury bill holdings as they fall close to the 'X-date' when the U.S. Treasury runs out of money.

While I still think cash is a great place to be to ride out a potential recession, I am adding to my USFR holdings while reducing my TBIL holdings to mitigate this principal repayment risk. I am reducing my rating on TBIL to a hold rating pending the resolution to the debt ceiling crisis.

I am 99% certain that the debt ceiling will be raised at the last minute, but one should never bet against politicians who may have alternative motives besides financial stability.

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