Don’t Fret the Debt

Debt. It’s a four-letter word, if you hadn’t heard—at least as it pertains to the US Federal Government. Some speculate current government debt is unsustainable. Or we’ll never pay it off. Or, or, or. All of which focus on the sheer size of outstanding debt—which some suggest totals $70 trillion! (It doesn’t—more in a bit.) But size alone says nothing about whether stocks and the economy can handle the US’s debt load. Affordability is the kicker, and considering US debt is very affordable by historical standards, it likely isn’t a headwind for capital markets.

Now, about that $70 trillion. It includes an estimation of all the US government’s possible future liabilities—all very speculative, not at all guaranteed to become reality. And more to the point, isn’t debt. Actual debt is simply the amount of Treasury bonds and bills outstanding—money the government has actually borrowed from the public. As of 8/14/2013, the US has $16.7 trillion. However, the federal government owns approximately $4.8 trillion of this—money the government uses to pay itself, which effectively cancels. Net debt held by the public sits at about $12 trillion—still big, but in order to know whether it’s too big, we have to scale it.

Many folks scale debt relative to total US output—a stand-in for total income. Current nominal US GDP is about $16.6 trillion, so net debt is almost 75% of GDP. Which still looks big! But in historical context, it’s not. Debt-to-GDP was much higher in the post-WWII era—over 100% at one point—and that didn’t prevent decades of growth and rising stocks. In fact, the debt ratio fell because of rip-roaring US growth! Not because the total amount of debt outstanding fell (point of trivia: It largely didn’t).

But scaling debt to the economy still doesn’t tell you the most important thing—whether the US can keep servicing its debt. This depends not on total debt, but total interest payments. Interest costs seem high, too—about $220 billion annually, as of 9/30/2012. Yet they’re about $21 billion less than the 1997 peak, thanks to falling interest rates—the 10-Year US Treasury yield is down from 6% in 2000 to 2.77% on 8/15/2013 and spent much of 2012 below 2%. Plus, thanks to a growing economy, the interest burden is quite affordable. Debt interest payments are just over 1% of GDP—down from 2-3% during the 1980s and 1990s—and just 9% of tax revenue. That ratio hit 18% in 1991—around the start of one of the US’s biggest bull markets and longest expansions. Pricier debt didn’t tank the US then, and cheaper debt should prove similarly easy to withstand today.

This is true even if interest rates rise from here. Rising rates don’t impact existing debt—they apply to newly issued debt only. With rates still near generational lows, most debt rolled over today is refinanced at still-very affordable levels. In fact, 5-year Treasury notes issued in 2008 are now being refinanced at roughly half the interest cost. Ditto for 7-Year notes issued in 2006. 10-Year notes are also significantly down since 2003. Even with the recent uptick, refinancing is saving the government money. It would take a material, lasting increase in rates to impact affordability much—and with default risk minimal and inflation expectations low, there doesn’t appear to be a catalyst for a sustained rate jump.

Not that endlessly adding debt is beneficial—but for now, there is ample evidence the US’s current debt isn’t a headwind for the economy or capital markets, nor an unaffordable beast.