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The determination of the current US administration to use debt to reignite the US economy has sent the government deficit soaring to new record highs, with potentially unsettling implications for bonds markets. Into the mix can be added a large dose of volatility around the outcome of the US presidential election in November.
Along with most western economies, the US government responded to the buffeting from the Covid-19 pandemic, geopolitical crises, and climate change by raising government spending. Under President Joe Biden, and powered by the 2022 Inflation Reduction Act (IRA), it has gone faster and further than other major economies.
The figures on the debt financing spree are stark and have taken the US economy into uncharted territory. US Department of Treasury figures show government debt had increased to $34.65 trillion in May from $34.61 trillion in April 2024. This is a new all-time high. Government debt in the United States averaged $5.6 trillion from 1942 until 2024. It stayed around those levels until the turn of the century, giving some idea how far outside previous norms the current debt levels are.
Up until recently there has been an aura of stability around yields on US Treasuries, but as the debt has risen to new peaks volatility has started to creep in.
The upward trend of US government debt and the usual political brinkmanship in Washington has raised eyebrows with some ratings agencies over the last year. Fitch and Standard & Poor’s have trimmed their ratings on US sovereign debt to AA+. Moody’s has retained its AAA rating, holding its nerve much in the same way as most insurer Chief Investment Officers (CIOs).
"Insurers acknowledge the debt level issue and rising servicing cost,
but don’t yet view it as a risk in their investment horizons."
It is not quite steady as she goes as there has been some reshaping of insurer investment portfolios, with a more nuanced appetite for long-dated bonds emerging among US insurers but, overall, caution has prevailed, said Kerry O’Brien, Head of Insurance Portfolio Management at Insight Investment. “There has so far been no sign of a near or medium-term shift in insurers’ view of US Treasuries. There is some long-term angst, but that’s not yet changing investment behaviour,” she said.
“Insurers acknowledge the debt level issue and rising servicing cost, but don’t yet view it as a significant risk in their investment horizons. A common belief is that politicians won’t force action to address the debt level until the risks become more immediate. The pain from not acting needs to be greater than the pain from acting.”
She said the response to the ratings agency downgrades doesn’t mean CIOs are ignoring potential risks of rapidly rising debt. “The market reaction when S&P and Fitch went to AA was muted. In fact, Treasuries rallied. It is possible this time could be different. I attended Spring IMF [International Monetary Fund] sessions where the risks of rising US debt levels were bluntly flagged. The most crowded session I attended was on the US ratings outlook.”
Central bank policies and the trajectory of interest rates will play a key role in shaping investment decisions over the next year, said Julian Le Beron, CIO of Core Fixed Income at Allianz Global Investors. “Fiscal deficits and debt issuance are set to remain elevated, while at the same time central banks are looking to reduce the size of their balance sheets, meaning a lot of bond supply will need to be absorbed by the private sector."
“However, against these fiscal challenges, we have already had a significant re-pricing in sovereign bond yields over the last two to three years, while inflationary pressures are not as acute as they were post-pandemic,” said Le Beron. “With labour markets also suggesting early signs of softening, the likelihood is that the US Federal Reserve will follow the lead of other G10 central banks and begin a rate cutting cycle later this year."
“In the second half of 2024 and into 2025, this is likely to present a more supportive backdrop for US Treasury total returns, as well as returns in other bond markets, especially after the repricing in bonds over the past 18 months.”
“Rising rates can lead to declining bond prices, negatively impacting the
value of their existing bond holdings."
This interaction between interest rates and bond prices could play out in a variety of ways, causing some readjustment in the balance of bonds in insurers’ portfolios. With the security of US Treasuries taken as read, apart from among a few outlying alarmists, these changes will be subtle.
“Insurers are highly sensitive to interest rate risk”, said Spencer Hakimian, founder of New York-based hedge fund Tolou Capital Management. “Rising rates can lead to declining bond prices, negatively impacting the value of their existing bond holdings. This is particularly crucial for insurers given their need for stable and predictable returns to meet future liabilities."
“Insurers might adjust their portfolios to manage duration and interest rate risk. They could shorten the duration of their bond holdings to mitigate the impact of rising rates or diversify into other asset classes that offer better risk-adjusted returns.”
With the US fiscal debt at unprecedented levels, it is hardly surprising that the bond markets are behaving in unexpected, even contradictory ways, ensuring CIOs and investment committees keep a sharp eye on trends, said Erik Vynckier, Chair of the Investment Committee at UK-based Foresters Friendly Society.
“The shape of the yield curve is odd. A bump in T-Bills – up to 1 Year and anchored high by Federal Reserve money market policy – and a high bump at 20 Year US Treasuries,” Vynckier said. “I suspect technical buying of duration impacts the 30 Year US Treasuries which is unattractively low for me. US inflation will only go down once the labour market develops slack, but this is unlikely at the current expansionary Federal deficit."
"More insurers are planning to increase duration exposure,
consistent with the Fed completing its rate hiking cycle."
“For me the rate policy has no obvious downward trend from here and nor does the yield curve present opportunities, other than the 10 year to 20 Year to 30 Year butterfly anomaly,” he added. This is a feature that has emerged over the last few years and is the subject of much comment and analysis among investors and managers. Typically, this is where a portfolio goes long on 20-year bonds and relatively short in nearer and further maturities, creating a non-directional trade that potentially enhances the relative value of holdings.
O’Brien said she also sees scope for modest repositioning of portfolios against this complex, almost contradictory background. “More insurers are planning to increase duration exposure, consistent with the Fed completing its rate hiking cycle. They are yield focused and, as such, generally prefer spread sectors over Treasuries, which are treated as a ‘defensive’ allocation,” she said. “An allocation to high quality, liquid treasuries is often used to anchor asset allocation, with the bulk of the fixed income allocation instead dedicated to higher spread products such as investment grade corporate bonds and structured products."
“That said, the sharp rise in rates means many insurers are sitting on unrealised losses, which is likely to be limiting asset allocation shifts.”
There is always talk among asset managers about a shift to alternative assets, especially when returns on bonds are flat and equities are flying high, as the US stock market is at present. They talk about the search for value elsewhere. Michael Ashley of Columbia-based Ashley Insights, and a former Chief of Staff at CitiGroup, is one of those who saw potential movement in the direction of alternatives if returns start to look less promising.
“When I suggest that insurers should diversify, it includes both alternative asset classes and geographic diversification. Insurers can reduce risks by investing in corporate bonds, real estate, and infrastructure, which often provide higher returns compared to government bonds, though they come with their own set of risks,” said Ashley. “These assets can offer steady income and potential appreciation that can help balance out the volatility in the bond market."
“Furthermore, looking beyond US government bonds to other stable economies like the EU, UK, and Japan can further stabilise insurers' portfolios. These regions can offer fixed interest elements that are less correlated with US economic fluctuations, providing a cushion against domestic volatility.”
Looking from the other side of the pond, European insurers might see opportunities in US bonds, potentially balancing out any marginal nervousness among US insurers, said Simon Richards, Head of Insurance Solutions with Insight Investment. He added that the US market was an attractive source for long-dated bonds for UK and European insurers seeking to lengthen duration to match liabilities. “They have been increasing allocations to US assets over the last few years, and the recent increase in yields has also made global investment grade bonds more attractive,” he said.
Richards said that allocations to US bonds have been achieved both through investment in specific US debt portfolios and through broader allocations to global credit where US debt is a key component. “Within global portfolios, insurers will expect their asset manager to take account of the prospects for US inflation and the Fed’s interest rate policy in the overall asset allocation and to therefore underweight or overweight as appropriate,” he said.
Just where will US interest policy go, and what are the prospects for inflation? This is where the uncertain outcome of the US Presidential election weighs most heavily, said Le Beron. “The key risk for bond markets going into the November US elections is the possibility of heightened volatility as markets assess the implications of future US trade and industrial policy.”
“There is something of a naïve belief that Trump will just continue to run
the IRA and other Biden commitments. I think not."
While demurring to mention either candidate by name, it is clear where he thinks the biggest risk lies. “The risk of more protectionism policies would raise inflation risks and pare back expectations of a Fed rate cutting cycle, whilst also endangering the US growth outlook in 2025,” Le Beron said.
In other words, a change of administration to one led again by Donald Trump.
Vynckier also saw the potential for a Trump presidency to be disruptive, perhaps more so than most insurers and their advisers are prepared to admit. “There is something of a naïve belief that Trump will just continue to run the IRA and other Biden commitments. I think not. He will cut and reverse Biden programmes and expenses wherever there is scope to do so, short of breaking past, signed contracts,” he said. “He will also cut international spending, such as on the United Nations, World Health Organization (WHO), NATO and sponsorship on behalf of others and on wars of choice abroad."
“I suspect that the tax cuts will – unusually – focus on the lower salaries, such as tax-free tipping and increasing thresholds on the low tax bands. Trump is a populist. Such lower taxes on the starter incomes might even produce an inflation spike in the typical consumer baskets bought by such demographics.”
The biggest – but least discussed – fear around a change in US administration is a sharp reverse in investment in infrastructure, especially the large renewable energy projects. There will be some close scrutiny of portfolios to identify the risks around infrastructure-linked assets as insurers will not want to find themselves holding large volumes of stranded assets. For many CIOs, the near-collapse of AIG in 2008 because of its excessive holdings of mortgage-backed securities and credit default swaps still haunts them. It is also one of the biggest brakes on any headlong rush into alternative assets, no matter how promising the short-term returns look.
If anything, this fear will boost the inflows into mainstream US Treasuries as the best sanctuary in a potential storm. That, in itself, will answer the questions about the sustainability of the growth in the US fiscal deficit. As long as institutional money is still flowing in, the debt can be financed.
