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What Happens to the Cost of US Debt if Interest Rates Rise?

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A realistic, detailed analysis of the future of the national debt.

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Editor's Note: This article was written by Robert Barone, head of Ancora West. Barone currently serves on AAA's Finance and Investment Committee which oversees $5 billion of investable assets.

Recent events have once again focused the markets on the the high-debt European economies with Ireland now effectively joining Greece on life support from the EU and IMF. Can Portugal (Spain) be far behind? (Most Americans and Germans would have a fit if they knew how much of the IMF commitments were borne by them!) During that first European debt crisis last spring, I blogged about the level of debt in the US (see "Wow! That's a Lot of Debt!"). Now, with quantitative easing, QE2, and trillion dollar structural deficits as far as the eye can see, I wonder how many people recognize the potentially devastating costs of the national debt as deficits continue, especially if interest rates start to rise as many pundits believe is fairly imminent.
This is an article about the cost of the national debt. But, to set the table, let's look at some data. The national debt currently stands at $13.7 trillion, and, under the most optimistic Congressional Budget Office (CBO) projections for 2015, it's projected at $17.4 trillion (based on 4.9% GDP growth between now and 2015). More likely, unless economic growth improves dramatically, the debt will rise to $20 trillion, perhaps $22 trillion in the next five years. The Federal Budget is nearly $3.5 trillion (23.9% of GDP) and CBO projects a Federal Budget of $4.2 trillion (22.8% of GDP) in 2015. Tax collections for 2010 are expected to be $2.1 trillion, of which $894 billion are from income taxes. CBO projects total taxes to rise to $3.7 trillion by 2015 (an 11.7% annual growth rate), and for income taxes to rise to $1.9 trillion (16.1% annual growth rate!). Clearly, such projections occurred prior to the recent elections. Today, for every dollar spent by the federal government, nearly $0.39 is borrowed. USDebtClock.org indicates that the six budget categories shown in the table account for nearly 86% of the federal budget.



The six categories shown account for nearly $3 trillion of spending and are 140% of total tax collections, indicating the nature and extent of the structural deficit. A few of these six categories have become "sacred cows" with any politician or would-be politician attempting to "fix" any of the four "social" categories (Medicare/Medicaid, Social Security, Income Security, and Federal Pensions) subject to vicious political attack. It also appears that these four are subject to fierce upward spending pressures as the population ages, the recession continues, and federal employee wages remain significantly above those available in the private sector (and rising!). As long as the US continues to fight two wars and must defend itself against the war declared on it by the jihadists, upward pressure on the defense budget will continue. That leaves interest on the debt.

The website TreasuryDirect.gov has a wealth of data concerning the national debt. As of October 31, the official debt was $13.689 trillion consisting of $8.497 trillion of marketable debt and $5.192 trillion of non-marketable. Debt held by the public (including foreigners), which consists of most of the marketable debt plus a few minor items (like savings bonds), was $9.07 trillion.

The remainder of this article investigates what happens to the cost of the debt if interest rates rise. It isn't a simple answer because the debt matures issue by issue on widely different dates. If a maturing issue, for example, has a coupon higher than current market conditions require, the total cost of the debt would fall. So, changes in interest rates take time to work their way through the debt maze. To analyze what happens to the cost of the debt, I made the following assumptions: a) the shifts in the yield curve would be parallel shifts; b) a maturing issue would be reissued to its original term (for example, an issue that matures on 11/15/2010 that was issued on 11/15/2000 (i.e., a 10-Year Note) would be reissued on 11/15/2010 at current market interest rates to mature 11/15/2020); c) the marketable debt ($8.497 trillion) is a close proxy for the debt held by the public ($9.07 trillion). While the "cost" of the $13.689 trillion is a number in the $325 billion range on an annual basis, the real cost of the debt is the cost of the portion held by the public because that is the net amount of interest to be paid out; the rest is just intra-governmental transfers. Some may argue that the budgets of those agencies must reflect the interest that has to be paid, but for this analysis I've used the "net" debt concept. The existing marketable debt (Bills, TIPS, Notes, and Bonds) has a weighted average maturity of 4.9 years and a current cost of 2.41%. The base yield curve used is the yield curve for Treasuries and the yield curve for TIPS on 11/15/2010 as shown in the following table:

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No positions in stocks mentioned.
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