Debt, Demographics, and Difficult Choices

Last week, many clients reached out with questions about the federal debt, Treasury yields, and reports that policymakers were taking steps to support the bond market. The concern is understandable.

The national debt recently crossed the $40 trillion mark, while long-term Treasury yields climbed meaningfully. That’s not a great combo. As yields rose, the Treasury Department announced an expansion of its buyback program for longer-dated bonds, a move that investors likely interpreted as concern on the part of policymakers.

Whenever markets begin debating debt levels, government policy, and interest rates simultaneously, anxiety tends to rise. Questions quickly follow. Is the debt too large? Will interest rates continue moving higher? Will policymakers become more involved in the bond market? What does this mean for portfolios?

The Long Road to Today

But first, a word on how we got here. Why is it that concerns about the national debt seem to persist decade after decade without a lasting solution?

Part of the answer is that debt reduction often requires difficult tradeoffs. Most citizens value lower taxes and generous government benefits today more than a smaller national debt tomorrow. Politicians generally understand the long-term importance of fiscal responsibility, but they operate in short-term election cycles, making it easy to postpone difficult decisions.

This is not a recent issue. The national debt has been rising every year since 2002. The financial crisis and Covid pandemic did not help, but policies and demographics did most of the heavy lifting.

A Historical Perspective

Today’s debt levels as a percent of GDP are very similar to the period following World War II. On the surface that is comforting. Afterall, the US successfully managed down those high debt levels. While that observation is correct, the circumstances were unique.

Following World War II, the US benefited from returning soldiers contributing to a rapidly growing population (the baby boom) and strong household formation, educational opportunities expanded (GI Bill), and the position of the US in the global economy elevated as the world rebuilt. Millions of young families entered their prime earning and spending years. Economic growth was strong, tax revenues expanded, and debt gradually became smaller relative to the size of the economy.

Today’s environment looks quite different. Population growth has slowed (lower birth rates and lower net migration), household formation has matured, the population is aging and programs such as Social Security and Medicare represent a larger share of government spending than they did decades ago, and the interest expense on the $40 trillion in debt continues to grow.

The “Solution”

At some point, concerns about the national debt may become important enough that voters begin prioritizing it alongside taxes, benefits, and other policy objectives. Like the WWII era, the solution will not be one magic bullet, it will be the combination of many small actions that add up to material change. Those actions fall into four major categories: Boost growth, boost productivity, increase revenue, reduce expenses. Potential illustrative examples include:

Boost Growth

• Reduce barriers to business formation
• Attract foreign investment with strong regulatory institutions
• Encourage population growth through births and immigration

Boost Productivity

• Invest in education and workforce training
• Fund research and development (R&D)
• Accelerate adoption of new technologies (AI, automation)

Raise Revenue

• Improve tax compliance and collection
• Increase income and corporate tax rates
• Broaden the tax base by reducing deductions and exemptions

Cut Expenses

• Reduce defense spending
• Reform Social Security benefits, Medicare and Medicaid spending
• Slow the growth rate of future benefit programs

None of this is easy, but there is certainly a path if the political will is there.

Back to Today

While the debt situation is real, this is a long-term problem. Investors today should not be assuming impending doom. The future is ultimately unknowable and investors will do better to focus on preparation rather than prediction.

Interestingly, as I was writing about the “solution,” I saw a parallel with our own process. We look for a series of small wins, which when added together have the potential to improve client outcomes. Factors… diversification… opportunistic rebalancing… expense management… tax efficiency, etc. There’s no silver bullet. Rather it’s the accumulation of actions, each designed to help client outcomes.

That is true in our bond holdings as well. Our strategies generally invest across the yield curve, including lower risk short-term Treasuries, and some long-term Treasuries. Last week’s action was at the long end of the curve. Those longer-term Treasuries (20-30 years) will react the most to concerns about the national debt. Our portfolio duration remains meaningfully shorter than the longest-maturity bonds that have been at the center of recent market concerns.

That does not eliminate risk. But our portfolios are designed with the understanding that interest rates, inflation, economic growth, and government policy can evolve in ways that few investors expect. Diversification across fixed income sectors and maturities helps reduce reliance on any single outcome.

The debt debate will likely remain with us for years. Whether policymakers ultimately choose spending restraint, stronger growth, financial market intervention, higher revenues, or some combination of approaches is impossible to know today.

Fortunately, successful investing does not require us to predict those decisions correctly. The answer is to remain diversified, stay disciplined, and continue focusing on long-term objectives while preparing for a variety of possible outcomes.