What would happen to a Treasury bill after it defaulted? Six key questions

By Karen Brettell

(Reuters) – The US Treasury risks defaulting on its debt unless Congress raises the debt ceiling before it is reached, which could happen as early as June 1. For holders of Treasury bills, notes and bonds, this creates uncertainty as to whether the issues they hold will be affected and what will happen if the debt is not repaid or an interest payment is missed.

Here are six key questions:

Do all bonds default if a payment is skipped?

No. There are no cross-default rules for government bonds, so a missed payment on one issue does not necessarily affect another issue.

So far, movements in the Treasury bill market have reflected local concerns about certain issues maturing in early June, when the US Treasury Department is expected to run out of funds. The yields on these notes trade at higher levels than comparable notes maturing later in the year.

WILL FANCY QUESTIONS STOP TRADING?

Analysts believe it is crucial that government bonds can continue to be transferred through the Federal Reserve’s settlement system, the Fedwire Securities Service. The Treasury can ensure that the securities remain on Fedwire by giving notice the day before that a payment will be delayed. This should be done daily until payment can be made.

ARE DEBT HOLDERS COMPENSATED FOR LATE PAYMENTS?

Analysts expect debtors will be compensated for the delay, but it’s not clear exactly how that would work. JPMorgan estimates that this would most likely take the form of a variable interest rate for missed coupon or bill payments.

However, the Treasury Market Practices Group said in a December 2021 document that “it would require express legislation from Congress to provide security holders subject to late payment of government debt with compensation for delaying those payments.”

In 1979, technical difficulties caused the Treasury Department to delay repayment of some Treasury bills. Investors who missed their interest or principal checks were compensated for the delay.

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Can the Treasury take over maturing debt?

Yes. According to JPMorgan, the Treasury can roll over maturing coupon securities on the due date without affecting its outstanding debt or remaining cash balance as long as it makes the coupon payment due on the same day.

With treasury bills, things are more complicated as they are sold at a discount and then redeemed at face value. However, some analysts point out that as the Treasury faces multiple bills on top of its debt payments, it is more likely to cancel auctions and defer debt payments once it hits its debt limit.

The Treasury Department on Thursday announced plans to sell 4- and 8-week bills and 161-day cash management bills on May 30. It has not yet announced any further auctions, which are expected to include more terms of Bills in early June.

Would rating downgrades result in forced sales?

Many bondholders, including money market fund investors, only buy very highly rated debt, and rating downgrades could affect demand. However, there are caveats that could limit large-scale forced sales.

Money fund rules and regulations don’t require immediate liquidation on default, JPMorgan notes, adding that fund directors likely have discretion to decide whether to hold or sell. Few of them would likely choose to sell defaulted securities at distressed levels.

Money market funds also invest in repurchase agreements backed by government bonds. However, short-term debt is not typically used as collateral. Longer-term debt with coupon payments due in the risk period may need to be replaced or face higher discounts, which are deductions from the value of the assets.

A default would affect the Treasury’s collateral with clearinghouses

Trillions of derivatives at clearing houses are secured with government bonds. As with repos, short-term debt is generally not accepted to secure these transactions, but government bonds with coupons that are at risk of not being repaid may need to be discounted further or replaced. Margin requirements could also increase due to increased market volatility due to an outage.

(This story has been re-archived to include the word “bill” in the caption.)

(Reporting by Karen Brettell; Editing by Alden Bentley and Alistair Bell)