5 Myths about U.S. government debt.

POSITION PORTFOLIOS TO WITHSTAND MANAGEABLE HEADWINDS RELATED TO THE FEDERAL DEBT.

As we approach a rising rate environment, the scale of U.S. federal debt has some investors concerned about the sustainability of government finances in the coming years. In this article we consider the most common myths about the government’s debt and discuss how investors can position their portfolios to withstand what we believe are manageable headwinds related to the federal debt burden.

Myth 1: The U.S. will default on its debt

Although much hype surrounds the possibility of a U.S. debt default, the likelihood is infinitesimally small.

One of the reasons the U.S. has been—and continues to be—a traditional safe haven for global investors is that investors know very well that the U.S. has nearly unlimited taxing power and a huge asset base. The federal government could—if needed—force liquidation of these assets to pay its entire stock of debt nearly 10 times over before defaulting. This is before even considering increasing taxes on the private sector.

Myth 2: The U.S. debt is out of control

The U.S. debt is at somewhat elevated levels, but the current debt-to-GDP ratio is quite manageable.

In absolute terms, U.S. government debt, measured as total debt held by the public, is $13 trillion—a record high (as of June 30, 2015). The debt-to-GDP ratio stands at approximately 74%; an elevated level, but hardly a record. The Congressional Budget Office (CBO), a non-partisan government organization, projects only a slight increase in net debt as a percentage of GDP—from 74% in 2015 to 77% in 2025.

Considering government debt from the vantage point of the annual federal budget, the federal budget deficit has declined steadily from 9.8% of GDP in fiscal year 2009 to an estimated 2.7% of GDP in 2015. It is forecasted to hover near 3% for the next few years, as shown in the chart.

Myth 3: Rising rates will explode the debt

While rising rates would certainly cause the government’s net interest expense—its cost to service the debt—to increase, it won’t cause it to explode.

Any rise in interest rates would almost assuredly be the result of a healthier economy and inflation expectations. This matters a lot, because if both GDP and the debt rise in lockstep, the debt-to-GDP ratio does not actually grow. In addition, much of the U.S. government debt that was issued in the past seven years was done so at record low rates. This cheap debt has locked in coupon payments, which will not increase as interest rates rise.

Myth 4: The budget problem cannot be fixed

The truth is that the budget problems facing our country are not difficult to solve from a mathematical perspective. The bigger challenge is finding the political will and the level of compromise and collaboration that would be required to make progress.

For example, according to a 2015 report from the Medicare Trustees, the trust fund supporting a significant part of Medicare costs is projected to be depleted by 2030. However, the present value shortfall over the next 75 years could be entirely covered if Medicare payroll taxes were increased by just 68bps, from 2.9% to 3.6%. Changes in the age of eligibility or the amount of benefits received are other feasible tweaks to handle the shortfall.

Myth 5: The biggest risk to investors is the federal debt

As the preceding arguments have made clear, the federal debt is far from the biggest risk facing investors. Nevertheless, investors should establish a plan to address a few manageable debt-related investment headwinds. These include:

• Solving for growth: For investors, getting an investment portfolio to grow in an era of slower overall economic and profit growth is an important consideration. While specific debt levels and their associated costs remain hotly contested issues among economists, it stands to reason that at a certain point, government spending on productive endeavors like investment spending on physical capital can be crowded out by increasing net interest expense.

• The income drought: Depressed interest rates are not directly related to the debt burden, but are rather a knock-on effect from slower growth and lower inflation. One of the serious consequences of low interest rates is that the traditional sources of investment income earned by investors and retirees have all but dried up. We do not expect interest rates to revert to pre-2008 levels anytime soon. For investors, it remains critically important to have a diversified approach to generating income without being overly concentrated in any single asset class.

Investment implications

Although none of these factors would necessarily mandate a change in core asset allocation strategy, they do suggest tilting to equities (and, in particular, growth-oriented equities), looking at alternative sources of income to counter low rates and utilizing tax-efficient strategies, where applicable.

Investors should not be distracted by wild and misguided prophesies of debt Armageddon. They should instead focus on working with their financial advisors on topics relevant to their own financial plans, such as getting their money to grow despite a slower growth environment, or cobbling together a more diversified stream of income in a low-yield world.