Andrew Mulliner and Ryan Myerberg, portfolio managers within the Global Bonds Team at Janus Henderson Investors, take a candid look at escalating US debt and the implications for bond investors.
It's all about lifting weights
We are not really talking about lending directly to Uncle Sam here, but the sheer size of the US economy (25% of world gross domestic product, GDP) and the history of the dollar as a reserve currency means the US bond market is the largest and most liquid in the world. It also dominates bond indices, which by their rules-based construction are weighted to the most indebted nations.
When it comes to global bond indices, the heavyweight is the US and its influence is getting stronger at close to 40% of the global bond indices (see chart), while, combined, the US, Japan, Germany and France account for two-thirds of the total country exposure. As a global bond manager, this concentration is one reason why we believe the index is not the best starting point for portfolio construction given these benchmark biases.
Figure 1: Breakdown of the Bloomberg Barclays Multiverse, %
Source: Bloomberg Barclays Multiverse Index, 31 October 2018
The bad news is this could be getting worse as the US is going on a borrowing binge. With the US economy booming and official unemployment at just 3.7% - the lowest in almost 50 years and below the Congressional Budget Office's estimates of the natural (or equilibrium) rate - one might expect some degree of fiscal responsibility, letting higher tax receipts boost revenues and building a buffer for the next downturn. In fact, the opposite is happening, with the tax cuts/spending programme likely to result in budget deficits of 5% of GDP in coming years ($1 trillion in cash terms for 2019). Since World War II, the US has posted budget deficits that exceeded 5% of GDP in just two periods - 1983 and from 2009-12 post the financial crisis.
Moreover, the US corporate sector has also been issuing debt at low yields to buy back shares and add more leverage to the balance sheet. This elevates earnings in the good times but will have the exact opposite effect in a downturn. The US investment grade corporate bond market has grown from $2trillion to $6.3trillion in a decade, and average credit ratings have deteriorated with BBB-rated companies (the lowest rung on investment grade) now representing half of that universe.
Figure 2: Congressional Budget Office deficit projections, $bn
Source: CBO, baseline projections, April 2018
In the near term, this spending boost has helped fuel a short term "sugar rush", which we expect to fade in 2019 due to the combined impact of tighter monetary policy and the fading fiscal stimulus, as the US central bank continues to raise short-term interest rates.
This cocktail of higher debt issuance and metronomic quarterly rate rises from the Fed, means the US Treasury will be refinancing more debt at higher interest rates. The average maturity of US government debt has been rising from its historic average of five years but it is still shorter than many other developed market peers. In practice, this means around two-thirds of outstanding treasury bonds will need to be refinanced in the next five years or so at much higher rates than before - around 3% based on current market levels, considerably higher than the average over the last decade.
Figure 3: Marketable debt outside the US Federal Reserve: maturity breakdown, % of GDP
US government debt is sensitive to higher short rates: most US government debt outstanding is <5 years maturity.
Source: Deutsche Bank Global Research, Treasury, BEA, Haver Analytics, October 2018
Higher yields must be good news for investors, right?
While the 3% yield available on US treasuries is the highest available since 2008 and is good news for US domestic savers, for overseas investors these higher yields are purely optical for those investing on a currency hedged basis. Higher short-term interest rates in the US are impacting hedging costs and depleting return potential for many non-US investors who invest in the US market. We anticipate foreign buyer demand to decline at a time when treasury supply will likely increase to compensate for government spending and a shortfall in tax revenues, a scenario that should pressure yields higher, all other things being equal.
Figure 4: Not much yield on a currency hedged basis, % yield after currency hedging
Source: Bloomberg, 31 October 2018
Some context needed
Given the dominance of the dollar for the financial system, the US government bond market remains a safe haven in times of significant stress. However, in a rising rate environment where the Fed is continuing to reduce stimulus, the diversification benefit of owning US treasuries is weakened somewhat. As a result, we continue to favour geographies where central banks are neutral or on hold, such as Australia and New Zealand, longer-dated bonds in Europe where the yield curve is relatively steep, and also Canada where rate hikes are fully priced and a high level of private sector indebtedness is likely to cap longer-term rates.
While the rest of the world remains coupled to US markets, they respond with varying degrees. The Fed is normalising faster than the rest of the developed world, which will perpetuate the divergence in policy rates and likely present attractive opportunities in global government bond markets.
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