By Ethan Gilbert
With recent headlines around the increasing national debt, our firm has had clients reach out to ask if they owned Treasuries and if the national debt is something that should worry them and their investments.
Most investors own U.S. government debt in some capacity. Whether it's a pension, an insurance product, a mutual fund or ETF, savings bonds, or a Treasury note, government debt is everywhere. Part of the reason it's so prevalent is because there is so much of it. Currently, the government owes $23 trillion and plans to add another trillion in 2020, making it the largest issuer of debt in the world.
Through the academic lens of investing, debt obligations of the U.S. government are assumed to be free of default risk as governments can print money. But through history we see that this does not always hold true.
Countries who let their debt get too large are forced to either print money or default. Neither is a good option, especially for investors. Could this happen to the U.S.?
It could, but it will likely be three or four decades until it reaches a tipping point, and even then, it's not a guarantee. In the meantime, investors should feel safe buying Treasury bonds; safe in that they'll receive their interest and principal, and safe that a buyer will exist should the investor want to sell them in the future.
First let's look at the bad, our country's fiscal health. The most relevant figure is debt as a percentage of the economy. Specifically, debt held by the public (excluding other government agencies). For the United States, that total is $17.1 trillion. The total size of the economy (gross domestic product, or GDP) is $21.7 trillion, putting public debt as a percentage of GDP at 79%.
This is high by historical standards, but not catastrophic. Countries that have defaulted tend to do so when debt as a percentage of GDP gets above 180%.
The credit rating agency, Moody's, and the International Monetary Fund (IMF) each publish reports assessing developed countries' "fiscal space" or how much additional debt they could incur before no longer being able to find buyers for their debt. Moody's and the IMF each give a few numbers when assessing the U.S. In general, we are OK with debt up to 200% to 240% of GDP, but would struggle above that level. The U.S. is thought to have a relatively large fiscal ceiling because of our size and access to credit.
The reason for the multiple numbers is the uncertainty on interest rates and the cost of servicing the debt. Looking at data from 1962 to today, our debt is at an all-time high (79% versus an average of 41%). However, interest rates are low. The U.S. 5-year note is yielding 1.62% versus an average of 5.8%. Because of this, the cost of our debt as a percentage of GDP is close to average (1.85% versus 1.90%).
This cost has been rising in recent years as debt keeps increasing and the yield curve has risen. Were interest rates to return to their historical norm, the cost of the interest would become quite burdensome. Say with debt at 140% of GDP, and interest rates at 5%, the cost of the debt would be 7% of GDP. That's more than a third of what our government raises each year through taxes.
Adding to the concern is the trajectory of our national debt. Since 1962, annual spending as a percentage of GDP has averaged 20.1%. In 2019, it will be 21.3%, by 2029 will rise to 22.5%, and by 2049 is expected to rise to 28.2%. Tax revenue will not keep up. Over the last 57 years, revenue has averaged 17.3% of GDP. This year it is expected to be 16.1%, by 2029 it is forecast to rise to 18.3%, and by 2049 will be 19.5%. In this scenario, debt held by the public would be 144% of GDP in 2049, and our annual interest expense would be 5.7%.
These projections come from the Congressional Budget Office's (CBO) annual "Long-Term Budget Outlook" which was published in June 2019. These numbers are derived from a set of assumptions based on current law. Unfortunately, the situation worsened in August 2019 when congress passed the Bipartisan Budget Act of 2019, which removed discretionary spending caps and didn't offset those costs.
In anticipation of this, the Congressional Budget Office includes in their Long-Term Budget Outlook an Extended Alternative Fiscal Scenario, which tries to forecast elected officials' propensity for increasing spending and reducing taxes. In this alternate scenario, come 2049 we have revenues of 17.6% of GDP and spending is 33.1% of GDP. Debt as a percent of GDP would be 219% and the annual interest component would be 9.4%. It's hard to imagine this alternate situation would fully come to fruition but as recent history has taught us, forecasts under current law don't seem to hold.
Estimating events 30 years away is guesswork at best, but it seems reasonable to think the United States would be reaching the point of insolvency in roughly 45 years, give or take a decade. A concern people have with budget issues is that waiting makes the future changes more difficult and abrupt. Like anything in life, if you plan ahead it's easier. But Washington is doing the opposite, they are making the problem worse.
Still, there is good news for investors. The market doesn't seem to mind our fiscal issues and markets are ruthless. When other countries have fallen out of favor with investors, buyers don't exist, yields skyrocket, and countries are forced to print money or default. Nothing close to that has shown itself regarding Treasuries, instead the opposite has happened.
On Aug. 2, 2019, the Bipartisan Budget Bill was passed into law. It eliminated the 2011 sequestration on discretionary spending and raised the baseline for future discretionary spending. The market didn't blink at this additional $1.7 trillion in spending over the next decade. Rather, within a month, interest rates on U.S. government debt declined to near record, or record levels, depending on the term. The U.S. 30-year, our longest-dated bond that in theory carries the most default risk, closed at a record low of 1.94% on Aug. 28. The market is clear, it doesn't much care about America's fiscal challenges.
This phenomenon of low interest rates is seen around the world. In August 2019, $17 trillion in global debt was yielding negative interest rates, and only $200 billion of that was in the United States. At the time this prompted investors to wonder why America's government debt couldn't get to negative yields. Negative yields are more a result of supply and demand than fundamentals. There is a lot of wealth in the world, and for those with a strong aversion to risk, owning negative yielding debt is a necessity.
The U.S. dollar is the reserve currency of the world. All types of institutions, companies, and people come across dollars and need to hold them for a period of time. Those who want a guarantee that their dollars will be returned purchase treasuries. This, along with other factors, should perpetuate strong demand for treasuries into the foreseeable future.
The situation in Japan may also relieve anxiety over the U.S. debt. Japanese debt currently stands at 238% and has been above 200% since 2009. Despite this high level of debt, over half of the outstanding debt trades with a negative interest rate. Factors supporting Japan's yields are that the country is currently running close to a balanced budget and over 90% of the country's debt is held within Japan.
America relies on foreigners for a larger share of Treasury ownership, about 30%. The following is a breakdown of America's nearly $23 trillion in debt.
- $6.8 trillion - Foreign holders (Japan at $1.2 trillion & China at $1.1 trillion)
- $6.0 trillion - other U.S. government agencies (Social Security, Military Retirement, FERS)
- $2.6 trillion - Pension funds
- $2.3 trillion - Federal Reserve
- $5.3 trillion - All other U.S. investors (U.S. based mutual funds and ETFs, state and local governments, banks, insurance companies, U.S. Savings Bonds, private investors)
While we don't have the same type of domestic demand that Japan enjoys, America does have a diverse form of debt owners reinforcing the argument that we have good access to credit.
Even if projections come to fruition in 40 years, the market may treat U.S. debt more like Japan than Argentina. Though we'd probably struggle to reach a balanced budget at that point.
When asked to identify the greatest threat to our national security, former admiral and chairman of the Joint Chiefs of Staff, Michael Mullen, and former Defense Secretary James Mattis have both cited the national debt rather than a foreign government or terrorist organization.
I agree, I think America's national debt is the greatest threat to the world's long-term prosperity outside of nuclear war (you could also argue a climate-induced catastrophe).
But from an investor's standpoint there is no reason to be concerned about the national debt or holding Treasury bonds in the foreseeable future.
About the author: Ethan Gilbert, CFA, CFP, holds a B.S. in Applied Economics and Management from Cornell University and is a fee-only adviser with Rockbridge Investment Management.