How Much Do We Owe?

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Summary

Not commonly discussed, our aggregate debt is currently $63 trillion, or 337% of GDP.

The good news is that debt service dropped in previous years with interest rates.

Higher rates began to pressure mortgage applications, but the full effect on the economy remains to be seen.

I reiterate my recommendation to maintain short bond duration, and add short-term corporates to the list.

In light of rising interest rates and the new President's proposed infrastructure spending plans, debt is beginning to get some attention. But how much do we already owe? Most readers probably know that the United States government amassed over $19 trillion in Treasury debt, roughly 100% of our GDP.

But in fact, that's only part of our obligations. In aggregate, we owe $62.6 trillion in non-financial debt as of Q2-2016 (see charts below). Households owe directly $14.5 trillion, the largest part of which is mortgage debt. Businesses and state/local governments owe commensurate amounts. The largest portion is Treasury debt, $19.4 trillion as of June 30th (up to $19.9 trillion today).

Federal, state and local debt are liabilities of taxpayers, albeit indirect. Debt is mostly owed internally within the U.S. A smaller portion is external - for example, $6.2 trillion of Treasury securities is held by other countries. In addition to this, there's financial debt and derivatives on the books of financial institutions - I'm not including it in the discussion today both because data is not readily available, and the true exposure for derivatives isn't clear. I'm also excluding future obligations of the government (i.e., of taxpayers) - for example, Social Security and Medicare.

Debt Outstanding, $ Tril., 20 Years

Sources: for Federal debt - the U.S. Treasury; other debt - Federal Reserve, yearly before 2010, quarterly thereafter. Data as of June 30, 2016. Chart and calculations by author.

Households were the only borrowers that de-leveraged after the financial crisis - household debt first dropped after the financial crisis, and increased by only 9% in 10 years. Business debt grew by 47% in that period. But government took up all the "slack": Treasury debt grew by 123% in the past decade through June 30th, and state and local debt rocketed by 168%. In effect, debt shifted from household balance sheet to the government's balance sheet - but continued to grow in total at above-5% annual rate.

Government debt at 104% of GDP is now the highest since World War II when it reached 120% of GDP. Total debt, at 337% of GDP, is near all-time high (some government data shows that it receded from 2009, though I'm not yet sure about the quality of the data).

The good news is that interest payments (debt service) have actually dropped since 2008. Household debt service now constitutes only 10% of disposable income, down from 12.75% in 2008 (see chart). It's stayed low due both to low rates and to disciplined de-leveraging by households. At the federal level, despite much lower average rates, interest already makes up 6% of government expenses as government debt ballooned. Interest is now the fourth-largest federal budget category, as I wrote in June.

The massive amount of debt isn't necessarily a problem in itself. But as a (supposedly) fiscally responsible society, we owe it to ourselves and to future generations (who will pay most of it) to make sure that the situation is sustainable not only in the 1% Treasury rate environment, but also with higher interest rates.

With Treasury yields up, interest rates at the household level are beginning to rise. For example, average 30-year new mortgage rate is up to 4.08%, the top of its 2-year range:

Higher rates are viewed as a drag on the economy, but the full extent remains to be seen. Mortgage applications, a measure of home financing, declined in the past few weeks, but the drop is not dramatic, at least not yet. On a 3-week average basis which smoothes volatility, applications are down 4.4%, the 6th largest decline in two years.

I will continue to update you on the economic effect of higher interest rates - please stay tuned.

Where To Invest In Bonds

In my Nov. 11th article, when the 10-year Treasury traded around 2.1%, I wrote "The 10-year yield is likely to rise somewhat higher, but should at least pause around 2.3%." A shameless plug - rates did exactly that, the 10-year Treasury paused at 2.3% for about two weeks, then resumed its relentless rise at the end of November, currently around 2.4%.

Here is performance for popular bond index ETFs since June 30th. As always, bond gains/losses are proportional to their duration.

  • Barclays U.S. Aggregate bond index (AGG, BND): -3%
  • iShares Investment-Grade Corporate Bonds (LQD): -3.6%
  • Long-Term Corporate Bonds (BLV, VCLT): -5.4% to -8%
  • iShares 7-10 year Treasury index (NYSEARCA:IEF): -6.1%
  • Long Treasury bonds (TLT, TLO, VGLT): -12% to -13%

Where next? The trifecta of market forces that drove rates higher, continue to be at work for now. The rise in yields brought them closer to attractive levels, but not there yet - please stay tuned.

As recommended in previous months, avoiding interest rate exposure altogether by investing in floating rate notes (FLOT, FLRN) paid off by not losing. My recommendation to active fixed income investors (that is, those not satisfied with buy-and-hold approach) to maintain short duration still stands at this time.

Although with 2-year yields up, they became somewhat more attractive, and so did 2-3 year corporate bonds (such as SCPB, VCSH). If you are ready to reallocate your portfolio, I would consider those four products. And as before, this is a defensive position - FRN's yield around 1%, 2-3y corporates 1.6-2%. There will be a time to reach out for yield, but not yet.

Disclosure: I am/we are long FLOT, FLRN.

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

Additional disclosure: Roman Chuyan is the president and general partner of Model Capital Management LLC, a Registered Investment Adviser. This article is for informational purposes only. There are risks involved in investing, including loss of principal. Roman Chuyan makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Model Capital Management LLC. There is no guarantee that the goals of the strategies discussed in this article will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any security.