Fortune magazine’s Allan Sloan poses some excellent questions and raises some ugly issues in his piece “Structuring the Treasury’s bet for a Long-Term payoff.” His central thesis is that the Treasury makes a mistake financing the majority of its new debt in the short term debt markets at .2% today rather than locking in long term (30 year) rates at about 3.6%. It is his belief that long rates are likely to rise as the US deficit increases. While he makes no judgment on the merits of a deficit driven stimulus plan, financing such long term deficits in the short term markets may make the near term savings extremely expensive in the long run.
Rates may rise regardless of what action the Treasury takes today, however, the actions taken today may make tomorrow worse than it need be. Rising rates are usually what happens when business conditions improve from recessionary levels. Financing an increasing deficit in the short term market today exposes the Treasury to greater refinancing risk in the future in what most likely will be a higher rate environment. Laws of supply and demand will also have an impact on the US Treasury’s cost of capital. The larger the amount to be financed, the more leverage the buyers will have in terms of rate demands. The Chinese are already talking about holding less dollar debt. Is this a precursor for a “Sino-Hold-Up” that would make John Dillinger proud? While there is still faith in the United States Treasury, that faith could have an unattractive price tag attached!
The implications for a rise in long term rates and strategies to minimize the long term interest cost do more than just add varying levels of incremental debt to our national balance sheet. Corporate bonds are usually priced on the basis of a “spread” over Treasuries. Higher Treasuries, regardless of the maturity, mean higher corporate borrowing costs unless spreads decrease; the exact opposite may happen in a rising rate environment. Weaker and smaller less-than-investment-grade companies can expect to be hit the hardest. In a worst case scenario, it is possible that no spread would be sufficient to compensate investors. To put hard numbers to this, in today’s market, B rated companies’ 8-10 year bonds are trading in the 14-15% range. Similar bonds of BB rated businesses are in the 10-12% range. Were ten year Treasury rates to rise 2.5-3% and spreads to remain constant, the cost of ten year bonds for B rated businesses would rise to 16.5-18% and BB rated bonds to 12.5-15%. Any upward movement in spreads would make rates higher, taking them to potentially prohibitive levels. Though such rates would not impact the cost of pre-existing bonds, they would be a severe impediment to the refinancing of maturing bonds and/or to finance growth or capital projects.
Dick Cheney was famous for saying that “deficits don’t matter.” Time will tell if he was right. What is for sure is that how deficits are financed can make a big difference!