The debt ceiling debate

One of the biggest political issues today in Washington is whether Congress will raise the debt ceiling. Aside from the effects on the country, investors may also be wondering, how this will affect their investments. The honest answer: No one knows.

The federal debt ceiling is currently at $14.3 trillion. This represents the amount of total debt the federal government can incur without a further authorization from Congress. Current projections have the government reaching this amount around Aug. 2. Essentially, this means that the Treasury cannot issue incrementally additional debt after this date to pay for such needs as Defense Department expenditures, salaries for soldiers, Social Security and Medicare payments, and a breadth of federal expenditures. Therefore, Congress must either raise the debt limit or risk not being able to meet their obligations.

The effect this may have on investments is incredibly uncertain. We are expecting to see a fair amount volatility in the market as we are getting closer to Aug. 2. One scenario would have investors selling off government bonds with the fear that Washington won’t make interest payments. This type of sell-off would raise interest rates as investors would demand a greater return for the increased risk. Rising interest rates would decrease values of both stock and bond investments. Rising interest rates would also hurt home values, hurting the overall economy.

But another scenario would be the uncertainty in capital markets would cause investors to flee to the relative safety of government bonds. This would cause bond yields to hold, resulting in the price of bonds being steady.

So, how does an investor deal with this degree of uncertainty? Diversification. It is not necessary to bail out of treasury entirely. Due to the financial uncertainty in Europe, treasury prices actually rose in recent weeks. However, it is never good to put all your financial eggs in one basket. Make sure to invest in a wide range of asset classes including international stocks and bonds or commodities.

Diversification will allow most investors to ride out a difficult period while doing the least amount of damage to their portfolio. During uncertain times, it is also important to have a longer-term view. Check your asset allocation to make sure it is appropriate for your time frame and risk tolerance.

In addition, amid the uncertainty that surrounds the debt ceiling debate, most investment advisors agree that one thing is certain: individuals should expect to pay more tax in the future. Therefore, besides asset allocation, effective tax planning is important as well. After all, it is not how much you make, but how much you can keep after taxes that matters most to your financial future.

As always, consult with your investment advisor for guidance.

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