3 Fixed Income Opportunities as Trillion Government Debt Raises Yields

There’s no way to paint a better picture than it is: the US has a lot of debt.

Expect to feel the effects of the national deficit on the fixed income market soon, said Charles Curry, senior portfolio manager of U.S. fixed income for asset manager Xponance. As spending increases, the government has to borrow more money, resulting in a greater supply of Treasuries in the market, which ultimately leads to higher interest rates.

The U.S. national debt hit a record high of $35 trillion in July, just months after passing $34 trillion in January.

And it’s only going to get worse. Regardless of who wins the November election, Curry doesn’t think the national debt problem will be addressed.

Reducing the national debt requires higher taxes and lower spending, both of which are highly unpopular policies. Given the hyper-polarized political environment, Curry sees no way that Washington will implement the drastic policies needed to bring the national debt under control.

“I don’t see any policymaker willing to cut it,” Curry said. “Everything they’re trying to fund is going to cost more. The biggest elephant in the room is the military, Social Security, that kind of thing.”

Moreover, the demand for social security spending will only increase due to demographic shifts, such as an ageing population.

The consequences of a sky-high national debt

Curry predicts that as the U.S. government accumulates more debt, investors will expect more Treasuries to enter the market and the yield curve will normalize.

About 17% of the ICE BofA Treasury Index, which tracks the performance of U.S. government bonds, will mature over the next two years. That’s about $2.9 trillion that the U.S. government will have to refinance. Thanks to the past few years of near-zero interest rates, coupon rates on Treasuries are lower than the yield on the Treasury index. That means market rates are higher than those on existing debt. As a result, the debt will have to be refinanced at a higher rate.

Then, interest payments on the government debt will continue to rise. Curry is concerned that a higher interest burden will create a crowding-out effect, where interest payments on the debt eat into the budget for other essential government spending.

There is also the question of who will buy the US government debt. Higher debt levels could weaken the dollar and reduce investor confidence in the US economy. Investors who do invest in US government debt will demand more compensation for the extra risk they are taking.

New Treasuries coming to market and higher interest payments on debt will cause the yield curve to steepen, Curry said. The yield curve has inverted since 2022, meaning short-term debt has yielded more than long-term debt.

“The curve would probably have to invert and steepen because we have a voracious appetite for debt. There’s more debt coming,” Curry said. “And at some point, there’s got to be a marginal buyer of that debt.”

According to Curry, the Fed will cut interest rates and the government will issue more debt, which will cause longer-term securities to yield higher returns, enticing investors to buy.

3 Fixed Income Transactions for a High Debt Environment

Curry has the following suggestions for fixed income investors as rising government debt causes more unrest in markets:

He advises positioning fixed income portfolios in the belly of the Treasury and corporate spread curves, with the aim of staying within the five to ten years duration. This allows investors to take advantage of higher yields now, but minimizes their exposure to the longest-dated bonds, which are likely to rise and therefore lose value. Right now, the spread between 10-year and 30-year bonds is relatively flat, meaning investors aren’t getting much extra compensation for investing in bonds with much longer time horizons, so Curry doesn’t see much upside in moving very far up the yield curve.

Curry also emphasizes investing in quality stable income. For those investing in corporate debt, be aware of the sectors you are investing in and look for solid business models and financials. Curry cautions investors against investing in credit within cyclical sectors, as those securities will be volatile in the current macroeconomic environment.

Asset-backed securities are another attractive area of ​​fixed income, according to Curry. This category tends to be more defensive and offers a good source of income.

“You get your revenue, but it’s backed by things like data storage, warehousing centers, fiber deals, things that have real assets and collateral,” Curry said.

In addition, they have a relatively short average maturity of three to five years, allowing investors to position themselves in the middle of the yield curve.