Your Money: A debt deal is coming, but then what?

The U.S. government will raise the debt ceiling - you heard it here first. But as a result, Treasurys should face a downgrade from their sterling "Triple A" rating.

That affects you, me, and any investors holding government bonds in their portfolios. But how?

Think about the federal government as a debt-ridden American consumer, with a ton of credit-card debt. Not only is the consumer borrowed to the hilt - and borrowing to pay interest - but he continues to go back to Congress for a higher credit limit.

If Congress and the White House agree, the government's $14.3 trillion debt limit will go higher by selling more Treasury bonds. Naturally, important folks like Federal Reserve Chairman Ben Bernanke argue the U.S. government must be allowed to get this higher credit limit, warning that a failure to do so would prompt a "major crisis" and send "shock waves" through the financial system.

Maybe so, but the market will do what the White House and Congress won't. A savvy lender won't keep giving the United States, that overspending credit-card-holder, more money. The United States' main lenders are China, foreign buyers of Treasurys, mutual funds, or retail investors buying U.S. government bonds.

A ratings downgrade could actually be very healthy for the Treasury market - and good for investors in the very long term. Here's why:

The U.S. government has been paying an artificially low interest rate on Treasurys for years (10-year Treasurys currently pay a puny 2.90 return). Now that the reality of America's fiscal problems has been recognized, long-term investors in Treasurys should start getting paid more for the risk of owning U.S. debt.

A compromise that raises the debt ceiling before Aug. 2 doesn't ensure that U.S. sovereign debt won't be downgraded. And the short-term fix that the emergency legislation would provide will still leave investors unsettled.

When the debt ceiling is raised - and it will be, because neither Democrats nor Republicans can risk not doing so - the United States won't technically default. Short term, that's good.

However, raising the debt ceiling does not solve the basic problem, and a downgrade (think of it as a lower credit score) is inevitable.

"While the consensus in the bond market is for a last-minute deal ahead of the Aug. 2 deadline, sentiment might be hit as rating agencies weigh in on the issue and the market is asked to absorb new debt," Abraham Gulkowitz wrote to investors in his latest July 2011 client letter,  The Punchline .

Just listen to the dire talk from Moody's: "An actual default, regardless of duration, would fundamentally alter Moody's assessment of the timeliness of future payments, and a Aaa rating would likely no longer be appropriate," the ratings agency said last week. The ratings agency added that if even a short-lived default occurred, "a return to a Aaa rating would be unlikely in the near term."

Standard & Poor's was more explicit: "Beyond the short- and medium-term fiscal challenges we see, we consider unfunded entitlement programs (such as Social Security, Medicare, and Medicaid) to be the main source of the U.S.'s long-term fiscal pressure. These entitlements already account for a little less than half of federal spending (an estimated 42 percent in fiscal-year 2011). By 2020, the hypothetical rating categories could be in the 'A' category; by 2025, in the 'BBB' category; and by 2030, speculative grade (the 'BB' category or lower)." And, S&P added, "we could lower our rating on the U.S. more than once before 2020."

It's not so much the government's ability to pay that worries the ratings agencies. It is America's unwillingness to get its fiscal act together.

Thousands of us hold mutual funds with Treasurys: Vanguard Intermediate Term Treasury Fund (VFITX) has exposure to U.S. government and quasi-government agency-sponsored bonds (80 percent in Treasurys). Vanguard Total Bond Market Index Fund (VBMFX) had 35 percent in U.S. Treasurys, 27 percent in mortgage-backed bonds, 18 percent in U.S. corporate bonds, and 10 percent in agencies, according to MarketScope Advisor data in March. The exchange-traded fund version of Vanguard Total Market Index (BND) has a similar asset allocation.

Fidelity Intermediate Bond Fund (FTHRX), the short-intermediate investment-grade bond fund, had relatively high exposure to U.S. Treasurys (35 percent) but minimal exposure to agency bonds (6 percent). Most of the remaining assets were in U.S. corporate bonds (28 percent).

Long term, the U.S. government will likely be downgraded as a creditor nation and have to pay a higher interest rate on Treasurys. That likely will hurt prices of the underlying bonds. However, in the long term, if you choose to act as a lender to the U.S. government (by buying Treasurys), you'll enjoy a higher rate of return.