Higher interest rates have not only hit consumer and businesses in the pocketbooks with higher interest costs but governments as they look to re-finance their growing debt loads.On Wednesday, November 1, the U.S. Treasury Department announced plans to step up the size of bond auctions to manage its growing debt amidst the higher interest rate environment. The department stated that it needs to issue $776 billion in the current quarter and $816 billion in the next quarter to re-finance existing maturities and provide funding for government operations.Why is the Treasury’s disclosure about its funding plan important for capital markets? Given that government debt is auctioned off to buyers, this information on the supply of new bonds coming to market helps buyers set their bid price and the resulting yield (return) they need to receive in order to hold government debt to maturity. Capital markets are very efficient in setting interest rates required to hold government, state/provincial, and corporate debt–considering different maturity dates and credit risk.
Background
The U.S. federal government debt has grown from US$405 billion in 1923 to US$33.2 trillion as of September 30, 2023. The average interest on the debt is 2.97%, which is low given government debt is now yielding around 4.5-5%. The current interest cost on the debt is US$879 billion annually, which is 14% of federal spending.[1]The largest holder of the debt at 39% is the U.S. Federal Reserve and other government accounts. The next largest holder at 24% is foreign investors, which are governments, pension, insurance and sovereign wealth funds. Next at 9% is U.S. domestic mutual funds, meaning retail investors through money and bond funds. State and local governments own approximately 5% and pensions funds at 4%. This above combined makes up 80% of the holders of the debt. The 20% balance is held by banks, savings bonds, and other deposit institutions.[2]
U.S. Debt Ceiling
This debt limit is imposed by Congress on the amount of outstanding national debt that the federal government can have. Once the government reaches the ceiling, it cannot issue further debt. Instead, the Treasury can use extraordinary measures authorized by Congress to temporarily suspend certain intergovernmental debt, allowing it to borrow to fund programs or services for a limited time. The U.S. government has never defaulted on its debt. In June 2023, President Biden signed legislation suspending the public debt limit until January 1, 2025.
Debt to Gross Domestic Product (GDP)
Although U.S. federal debt has almost doubled in the last decade, investors focus more on a country’s ability to pay its debt rather than just the absolute amount outstanding. Investors look at the ratio of debt to GDP since it shows debt relative to the size of the economy. The U.S. ratio stands at 123% debt to GDP, while for comparison, Canada is 100% and Japan is at 260%. Meanwhile, economists typically look at net debt (debt minus government assets) to GDP as an indicator of government financial health.
The Bottom Line
Although the size of the U.S. debt and the political theatre around the debt ceiling always make the headlines, for long-term investors, they are irrelevant. The main issue is if the economy is growing and by how much to ensure that over the long-term service costs can be paid.Regarding portfolio implications, the level and direction of interest rates are more important. The global rise in interest rates over the last 18 months has also increased government debt costs. Government bonds, a low-risk, low-return investment for the last few years, offer competitive returns with stocks. As a result, money market and bond funds have seen massive amounts of capital inflows in 2023.As capital allocators, we look to make the best risk-adjusted allocations between cash, bonds and stocks based on where we are in the economic and market cycles.