No one really knows what would happen if the U.S. couldn’t pay its bills. But the impending debt-ceiling smackdown in Washington, D.C., makes planning for a possible federal default necessary, Bank of America CEO Brian Moynihan told “CNN This Morning” last week.

Few observers foresee default actually occurring. If it does, severe global financial damage would ensue, experts warn. International relations might rupture, too. How would China take Uncle Sam’s failure to make good on some of the $867 billion in U.S. Treasurys it held at the end of 2022?

Advisors are already fielding questions from clients about a potential default, even though the “X date” marking the end of America’s bill-paying ability won’t arrive until July at the soonest, according to a February 15 report from the Congressional Budget Office (CBO). As America’s date with fiscal destiny nears, advisors can anticipate mounting client queries.

One advisor said he is proactively owning the conversation. “We communicated heavily with clients during the debt ceiling flare up in 2011 and are readdressing the topic today with the families we work with,” said Wes Moss, managing partner and chief investment strategist at Capital Investment Advisors in Atlanta.

Moss believes federal spending cuts are an inevitable part of whatever final accord the politicos reach. That would adversely impact defense, healthcare, information technology and other companies deriving significant revenues from the government. “Clients are focused on how the sectors and companies they invest in would be affected,” he said, adding, “We are not raising cash at this point.”

Looking back, 2011’s debt-ceiling feud ended with spending cuts that shaved roughly 0.75% from gross domestic product, according to Preston Caldwell, chief U.S. economist at Morningstar. He’s not overly concerned about a blow to GDP now, though. The Fed has room to lower interest rates if Congress delivers a negative fiscal shock, he said.

Taking too long to come to agreement in Washington could hurt businesses because a delay in Social Security payments, let alone a reduction in them, could dampen consumption, said Jay Spector, a partner at Barton Spector Wealth Strategies in Scottsdale, Ariz.

Divergent Possibilities For Government Paper
“A lot of financial advisors and their clients have been raising concerns about the debt ceiling standoff in Congress and its impact on U.S. Treasurys,” Jerry Woytash, a PIMCO portfolio manager, said in a recent video on the bond-fund company’s Web site.

A January 31 article Woytash co-authored explains that the Treasury’s ability to issue new securities will eventually “bump up against the debt ceiling.” So in the coming months, the supply of T-bills will fall, paradoxically causing them to richen and their yields to drop. “A flight to safety into bills resulting from broader market risk aversion could further push down yields.”

But if the debt limit is ultimately increased, the article continues, Treasury would then swiftly rebuild its cash with new issuance, which should “cheapen Treasury bills—along with other money market products—and provide cash investors opportunities to earn extra yield.”

Alternatively, an actual federal default could “irreparably” shake investors’ confidence and “cast doubt on the U.S. government’s fiscal health,” said Morningstar’s Caldwell. “That could lead to increases in yields and cause risk premia to soar across the board.”

But the markets see that outcome as unlikely, advisors said.

Right now, “credit default swaps are pricing in a worse credit worthiness for the U.S. than Italy. However, the Treasury markets are not pricing in anything close to this level of concern,” said Joseph Hosler, a managing principal of Auour Investments in Wenham, Mass.

The Talk With Clients
When clients ask about the debt debate, acknowledge their concern and help them avoid panicking. “Overreacting could lead to portfolio underperformance,” said Bruce Primeau, president of Summit Wealth Advocates LLC in Prior Lake, Minn. “We help our clients understand they should not allow short-term issues to cause a deviation from their long-term asset allocation, because if you look at the long-term impact of issues like this, there really is no bearing on investment returns."

Advisors note this isn't the first time Congress has been deadlocked overr the debt ceiling.

“In 2011, the S&P 500 index fell more than 16% over the five weeks leading up to the deadline for raising the debt ceiling but recovered afterward,” said Susan Hirshman, Phoenix-based director of wealth management at Schwab Wealth Advisory.

Market volatility spiked in 2011 as the deadline drew closer. As it approaches this year, it’s important to understand clients’ liquidity needs. “Confirm that they have a financial cushion with enough liquidity and stability to weather any market downturn, so they’re not forced to sell volatile investments at depressed prices,” she said.

Near-term, though, Hirshman anticipates muted market reaction. “In the next few months, economic, jobs and inflation data, as well as the Federal Reserve's interest rate strategy, are likely to have a much larger effect on investor sentiment than the looming debt ceiling drama.”