Chained Down By Debt, Interest Rates Are Going Nowhere Fast

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Summary

U.S. debt repayments have remained manageable only via very low interest rate policies.

Each 0.25% increase in average interest rates cost the Government $40bn per year.

Government debt is heavily front-loaded with 50% of debt maturing within 3 years.

As a result debt payments will respond rapidly to rising interest rates.

The government can not afford interest rates to rise.

Not many market participants can go long without discussing interest rates. Where are they headed, whether they will rise, and how fast the central bank will do so. However, it is imperative to understand the mechanics of government debt and how they will be affected by interest rates to make any reasonable projection of the future for stocks (NYSEARCA:SPY).

It is no secret that U.S. debt has been rising, along with interest payments, however, a deeper understanding of how U.S. debt is structured allows investors to make a more informed decision when positioning themselves for the next decade in the market. While I understand that interest rates are used to control the contraction and the expansion of markets, I also believe that extraordinary levels of debt, accompanied by stagnating growth will lead to permanently low-interest rates. That is - until the debt bubble can be solved. Budget deficits are now the regular activity of government around the world, debt is growing, and low-interest rates allowed the government to continue to borrow despite stagnant growth.

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Source: TreasuryDirect.Gov, and FRED

While the deficit as a % of GDP has reduced significantly from the height of the great recession, even optimistic assumptions on deficit numbers imply a growing deficit of $400-$600 bn per year. The knock-on effects of permanent deficit spending will not be seen for several years, and perhaps more than 10. However, the time will come to deal with the issue. For now, we are left to speculate on the future of interest rates as an important input to valuing investments.

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Source: U.S. Treasury

Interest Rates

I am aware of the dangers that low rates are bringing into the economy, the growth of return chasing risk-on behavior has fueled a debt bubble, and governments have used low-interest rates as a means of funding expensive social programs without the critical examination that ensures they are performing well. The result has been gratuitous spending on programs that return less than a dollar for each dollar in, and a lack of accountability for the programs enveloping our tax dollars. As I look at the U.S. debt, as the world's leading economy, I see an inability to raise interest rates. The knock-on effects to the economy will be left for another article.

Average Interest Rate Payments and Total Debt

One of the most important points to understand is how quickly interest rates will follow through into interest payment growth. To get an idea of how much low interests have done to reduce debt repayments, the two charts below show a plethora of information, with an important conclusion:

The average interest rate paid on total U.S. debt has been declining for decades T-Bill rates, which make up a large portion of U.S. debt, have been near 0%. Despite the two points above, total debt payments have hardly budged while total debt has skyrocketed

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Source: TreasuryDirect.Gov, and FRED

It is clear that if the average interest rate paid by the U.S. government on debt were to rise significantly above its current rate of 2.33% (Dec-15), then U.S. debt repayments would follow and skyrocket as well. This inevitably increases the deficit figures above. In fact, a doubling of effective interest rates would increase U.S. debt repayments by over $400 bn per year, effectively doubling the projected U.S. government deficit.

Debt Maturity

Some may bring up the point that the average maturity of U.S. debt is nearly six years, and thus an immediate rise in interest rates would not immediately lead to an increase in debt repayments. This argument would be wrong. In fact, the average maturity of U.S. debt will likely continue to rise despite debt issuance of earlier maturity obligations.

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Source: U.S. Treasury

As Matthew Klein from Alphaville points out, the assumption that a lengthening maturity profile is due to an increase in the duration of debt being sold is incorrect. In fact, as we can see below, new debt issuance has been declining in maturity. This has to do with the front loading of debt. The treasury has been steadily increasing's its supply of medium term debts, while decreasing its supply of very short term debt.

As new debt has reduced in age to maturity, so have we seen a rise in the issuance of Treasury notes over treasury bills. For more information check out Winthrop Smith's article on the issue.

"The reason the short-term share rose so much is that the sheer volume of new debt, which had a much shorter average maturity than the existing debt, swamped the existing supply. From July 2007 through November 2008, the size of the debt grew by a third." - Alphaville

Each year, the government stabilizes the spread of debt and, as a result, the profile of repayments are less front-loaded, hence the rise in Treasury notes starting in 2009. However, this cannot happen overnight. For the sake of the argument here, the most relevant takeaway is the fact that the vast majority of U.S. debt issuance is via short-term treasury bills. It takes time to move the structure away from a front loaded one, and hence the structure of debt exists in a way that makes it difficult to raise interest rates. Front loading invariably leads itself to quick reactions to rate increases.

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Source: Winthrop Smith Via Alphaville (left) and Data Via SIFMA (right)

Front Loaded Debt

The majority of U.S. debt is short term, with just under 50% of U.S. debt expiring in less than 36 months as of 2015, the U.S has been slowly changing the debt structure out over time by replacing short-term debt with intermediate term debt.

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Source: SIFMA and Author's Work

This is especially apparent when we look at the distribution of maturities over the past decade. We have seen a sharp drop in very short term securities (1 year) and a steep rise in 1-5 year securities, accompanied by small weighted increases in 10+ year debt. It's not unreasonable to conclude that the Treasury is attempting to:

A) Take advantage of very low interest rates as demand exists to lock in very low rates

B) Distribute the maturity curve so that an interest rate rise is not immediately damaging to the government deficit

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Source: U.S. Treasury and Author's Work

How Quickly Will Interest Rate Increases Lead to Increased Debt Repayments

We know that, as of 2015, roughly 24% of U.S. debt has an expiry date less than 12 months, another 15% expires between 12-24 months, and 10% are due to expire within 24-36 months, making up a total of 49%. Nearly 50% of all U.S. debt expires in less than three years. If interest rates started to rise, the average debt repayment would lag actual interest rates. However, the effect on bottom line payments would occur quicker than many would think.

Within one year of a rate rise, a quarter of all U.S. debt would be issued at that new rate, not forgetting the $1 trillion plus that is retired annually ahead of maturity. Within three years, at least 49% of interest payments would reflect higher interest rates.

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Source: SIFMA and Author's Work

Wrap-Up

It is evident from the data and structure of government debt that a rise in interest rates will quickly be reflected in public debt repayments. As the government already runs at a deficit, increased interest rates will have the effect of increasing the deficit as well. A quick assessment shows that a doubling of effective interest rates on all national debt from 2.3% today to 4.6% would increase interest payments by $400 bn, doubling the current deficit. Larger deficits mean ever increasing debt repayments, and thus, the government is solely dependent on low-interest rates to survive. It is clear that the government has started a multi-year program to capture low-interest rates. However, the majority of U.S. debt still matures in less than three years. The result is that interest rate rises will quickly affect the deficit.

Making a model to examine the outcome of rising interest rates is the best way to visualize how rising interest rates will affect debt repayment over time. Head to the top of the article and hit the follow button next to my name to get that model, and future articles on commodities and macroeconomics.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Many of the assumptions are opinion based or inferred based on available information. This article is not, and should not be considered as, financial advice or an accurate view for investment purposes.