Insatiable demand for safe haven U.S. government bonds is helping mask a potentially huge financial problem — the need to extend the maturity of debt issued by the United States.
The United States has the least balanced maturity schedule of any major nation. Over 70% of its bonds mature within five years, compared with an average 49% for the 34 member countries in the OECD.
This leaves the country extremely vulnerable to any shift in investor sentiment at a time when its debt load has almost doubled in four years.
Marketable U.S. debt has risen to over US$9-trillion, from around US$5-trillion in late 2007, before the government increased spending to bail out struggling financial companies.
If sentiment were to shift quickly, it could send the cost of refinancing the country’s bonds sharply higher. This would, in turn, eat into its budget and ability to meet long term obligations.
In a worst-case scenario the country might not be able to refinance at all.
“There has never been a single example in the history of finance where financing long-term liabilities, which we are, with short-term debt, ends well,” said Mitch Stapley, chief fixed income officer at Fifth Third Asset Management in Grand Rapids, Michigan.
The Treasury has been extending the average maturity of its debt. However, with proportionally few longer-term bonds and large long-term liabilities, more work is needed.
Though some of these worst-case scenarios for U.S. debt might appear unlikely, Standard & Poor’s recent downgrade of treasuries should serve as a reminder that once unshakable confidence in the United States can come under question.
The downgrade occurred after an acrimonious political battle over dealing with the debt, which raised concerns over the country’s ability to address its fundamental issues.
DOLLAR RESERVE STATUS SLIPPING
The U.S. benefits from bond investments by foreign central banks, funds and other investors that has made Treasuries one of the largest and most liquid markets in the world.
This investor interest has helped benchmark 10-year rates fall near 2%, among the lowest rates in the world.
There is no guarantee, however, that demand will continue. U.S. debt demand is closely linked to the dollar’s reserve currency status, and this is slipping.
The Treasury Borrowing Advisory Committee, which comprises 14 industry representatives from banks and asset managers, has warned about the dollar’s reserve currency status.
“The idea of a reserve currency is that it is built on strength, not typically that it is ‘best among poor choices’. The fact that there are not currently viable alternatives to the U.S. dollar is a hollow victory and perhaps portends a deteriorating fate,” the committee said in its August presentation to the Treasury.
China, which holds over US$1-trillion in Treasuries, has said it wants to reduce its reliance on the dollar.
The U.S. Treasury has succeeded in extending the average maturity of its debt to 62 months, out from less than 50 months in 2009. That process needs to continue.
“We need to start thinking about the debt maturity schedule from the perspective of it being with us” for a while, said Colleen Denzler, head of fixed-income strategy at Janus Funds, in Denver.
The high U.S. debt load differs from previous periods where the perspective on the obligations “was that at some point it was going to potentially go away.”
Historically low interest rates make now a good time to term out debt. The government will face challenges, however, in doing so without also reducing the liquidity and reliability of issues that draw in many investors.
TWENTY, FIFTY YEAR BONDS?
“The rallying cry of U.S. Treasuries has always been regular and predictable,” said Michael Cloherty, head of U.S. interest rate strategy at RBC Capital Markets in New York.
Terming out debt to longer maturities, without disrupting this dynamic, may be complicated.
“When you’ve got $10 trillion in place you’re limited in how opportunistic you can be,” Cloherty added.
To meet demand from pension funds who need long-dated assets to match to their liabilities, some have called on the government to sell bonds that mature in 50, or even 100 years.
How much demand these bonds would attract relative to short- and intermediate-dated debt, however, is questionable.
“When you go from 10 years to 30 it’s much more difficult to know the prospects of the United States, so investors are going to require a higher risk premium for that,” said Janus’ Denzler.
One sign that investors are more nervous about longer-dated bonds is that the yield gap between 10-year notes and 30-year bonds, currently the longest U.S. maturity, is trading at 137 basis points.
This gap has risen from less than 20 basis points in mid-2007 and is less than 30 basis points from its record wide of 160 basis points reached in November 2010.
If this gap continues to expand, the government may look at alternative maturities such as 20-year bonds, rather than extending to ultra-long maturities, said Denzler.
“That would be an incentive to bring in a 20-year, because you may have buyers that have a degree of confidence in 20 years that they don’t have in 30,” she said. “Potentially that gap of 10 years is too much.”
Financial Post
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