Here's What Will Happen to Your Investments if the U.S. Defaults on Its Debt Next Month

The idea that the U.S. might not be able to pay its bills is simply mind blowing. So much so that right now, many investors -- some of whom have done this dance before -- are fairly sure it won't happen. However, if lawmakers can't agree to raise the debt ceiling in the coming weeks, the unthinkable may become reality and the world's largest economy might default on its debt.

To be clear, the chances of this happening remain extremely slim. But the consequences would be devastating, not only for your investments, but also for the country. Treasury Secretary Janet Yellen is warning of an "economic and financial catastrophe" on social media. JPMorgan CEO Jamie Dimon is also using the word "catastrophic." Let's dive in and find out what's going on and what it might mean for your investments.

What is the debt ceiling anyway?

The debt ceiling or debt limit is the amount the U.S. can borrow. The country runs at a deficit -- it spends more than it brings in -- so it needs that borrowed money to continue to pay its bills. It's a bit like a limit on a credit card. Lawmakers in Washington need to approve any increase to the limit. With a divided government, it's proving difficult to find a consensus.

Right now, the debt limit is set at just over $31 trillion, a point the U.S. crossed in January. Since then, the Treasury has been using so-called extraordinary measures to move money around and meet its obligations. But time is running out. Yellen says the Treasury might exhaust these measures in early June. 

Has this happened before?

The debt ceiling was established over 100 years ago. According to the Congressional Research Service, it's been raised more than 100 times since then. Indeed, Congress has always increased the limit when needed: It would be unprecedented if it does not raise the debt ceiling in time. The closest we have come to the brink in the past was in 2011 when, per Vox, the U.S. came within 72 hours of defaulting on its debt. 

OK, so is it all just doom mongering?

Without getting into politics, think of it like a game of chicken. Nobody wants to crash the car, but there's some serious brinkmanship going on. For investors, one difficulty is that the closer we get to the edge, the more panic there will be and the more confidence will be eroded. In 2011, when the U.S. came dangerously close to default, Standard & Poor’s downgraded America's credit rating. The stock market dropped dramatically, though it rose again by the end of the year.

How would an actual debt default impact my investments?

There are a couple of different scenarios in terms of a default. A brief one, where let's say the U.S breaches the debt ceiling and lawmakers quickly resolve the situation. Or a protracted one, which White House analysts warn could trigger a sharp decline akin to the Great Depression. In the case of a protracted default, it's estimating a 45% drop in stock valuations. Bear in mind that this figure comes from a group of people who want the debt ceiling situation resolved as soon as possible. Even so, the prospect of your investment account or retirement fund losing almost half its value is pretty dire.

A recent UBS research note described an outright default as a "disruptive event that could spark a sharp sell-off in stock prices." However, it says it is difficult to know how bad it will be because this has never happened before. "Because a default would be unprecedented, the magnitude of the market decline is difficult to estimate, but we would expect it to be very meaningful," continued the report authors.

We're already seeing the effect on Treasury bills, which are usually viewed as a safe investment. Bond markets would also suffer. Indeed, even without a default, if uncertainty causes credit rating agencies to downgrade the U.S., it would impact the value of all government-backed investments.

Why aren't stock markets already crashing?

According to the Financial Times, there are two reasons for "relative calm" on the stock market. "One is that analysts and investors broadly believe cool heads will prevail," it writes. The other? "Just as it is not possible to be a little bit pregnant, 'it is hard to price in a little bit of default.'" 

How can investors react to all this? 

Faced with such a dramatic potential drop in the value of your portfolio, the temptation to sell is understandable. But this may not be the best move. What if you sell today, and politicians agree to raise the debt ceiling tomorrow, causing prices to shoot up in a relief rally? Having an emergency fund and a diversified portfolio helps, but It's difficult to mitigate the risk of an unlikely yet potentially catastrophic event.

It's good to be aware of the debt ceiling debate, but try not to make panic investment decisions, as these rarely work out well. As a buy-and-hold investor, it's worth remembering that the stock market eventually recovered after the 2011 drop. Indeed, over 40% of financial advisors surveyed by SmartAsset said that riding it out may be the best way forward.