In mid-November the U.S. Treasury will run out of borrowing authority and thus run out of cash unless Congress increases the deficit or raises taxes. There is the risk that members of the House of Representatives will not allow a debt extension bill unless their demands are met and for which the president would not agree to accept these demands. This could result in a repeat of the July 31, 2011 crisis where the government almost defaulted on its debt, or it could lead to default.
   The main paradigm in bonds is that the worse the economy gets the more that people seek to buy sovereign debt from the giant “print and pay” nations thus causing rates to go down in times of crisis. This then acts to pull down rates for other investment grade bonds despite rising macroeconomic risks.   
    But what if the Treasury defaulted, then the longstanding paradigm would be broken. There is no way to know what would happen. In theory, if the Treasury defaulted, then global investors would demand higher rates for all types of investment grade bonds right at a time when a crisis would imply that rates for high quality investment grade bonds need to go lower.
  If the Treasury defaulted then many institutional investors who are compelled by contracts to deposit Treasuries so they can issue derivatives, etc. would be in default themselves and would need to replace their holdings of U.S. Treasuries with sovereign debt from a few small countries like Switzerland that have AAA ratings. Since there is not enough AAA rated sovereign debt for every institutional investor who needs it then this would cause an absurd situation of extremely high priced bonds which would mean a significant degree of negative interest rates would exist.
   Presumably a repeat of a last minute solution like that of July 31, 2011 would be found. But one must remember to be aware of the risk of Black Swan events. In a world where, except for northern Europe and the U.S., much of the world’s economy is weak and getting weaker there is significant risk that a triggering event like a Treasury default could cause a repeat of the October 19, 1987 crash where stocks fell 23% in a single day. However since the globe has twice as much debt in proportion to GDP now as it did back then that means risks of recession are greater than before.
   The U.S. government debt truly is very low risk except for the risk of the artificial problem of Congress and the president not being able to reach a debt ceiling agreement in a timely manner.
  If a huge bond market crash did occur it would probably be a temporary panic and not a sign of intrinsic value. Such an event would be deflationary and would make the value of investment grade bonds go up in response to the threat of falling into a depression. However, at first a temporary panic would raise the risk premium for Treasuries thus raising rates on all types of bonds such as corporate, mortgage, muni, etc. After a while people would realize the economy had crashed because of the panic and intrinsic fragilities of the economy and then investors would seek the safety of sovereign debt after Congress and the president had reached an agreement.
   The end of the world didn’t come when Lehman failed or when stocks crashed in Oct., 1987. Even with the threat of a default Treasuries are still a good credit risk in a world full of bonds that have unsafe credit quality. The risk of default is that it would change consumer confidence and make Americans act in a long term deflationary manner like in Japan and then we would be stuck in a long term recession.
   Investors need independent financial advice about the risk of a Treasury default. I wrote an article about this in 2011 “Treasury deficit crisis“..