Increasing Debt Through Refinancing

Being tax-day, I thought I would go through a small exercise in looking at the effects of rising interest rates on refinancing the national debt. I have based my thoughts on the premise that the federal government is going to have to refinance a large portion of its debt in the face of rising interest rates. For example, the average dollar of government debt will come due in less than five years and with the government simply refinancing its debt, this dollar will be borrowed again at a higher interest rate. I decided to use a rudimentary model and look at some potential consequences.

To complete this exercise, I used a number of assumptions to simplify this model. First, I assumed that all bonds mature in either 1, 2, 5, 10 or 30 years - respectively: .239%, 1.036%, 2.572%, 3.84% and 4.714%. Obviously there are other maturities, however, the model became increasingly complex for each added maturities. From this assumption, I gathered the interest rate for each of these maturities from CNBC and then looked at the national debt clock for the $12.8 trillion dollar debt number. Secondly, I did not look at any expansion of the national debt. I eliminated new spending or tax cuts from the model and held the debt constant. Again, this was to simplify the model. Yet, if new debt was included it would exponentially increase the cost of financing public debt as it would likely be done at higher interest rates. My next major assumption was that a constant portion of each maturity comes due each year. For example, this year 1/2 of the 2 year bonds need to be refinanced, 1/5 of the 5 year, etc. Meanwhile, all of the 1 year bonds will mature. Finally, I assumed that the average maturity was just under 5 years. This affected how each maturity was weighted. The first two segments were 35%, the third was 15% followed by 10% and 5% for the remaining maturities.

Based on this rather simple model, I determined that on $12.8 trillion of debt, the annual payment is about $187 billion, or 1.45%. I'm sure my numbers are not totally accurate, but my goal here is only to look at the effects of increasing rates on the financing costs.

Next, I looked at future years under several different scenarios. Each of these years assumed that the fraction described above would mature and be refinanced while the remainder of the debt would remain at the old level. The first situation I looked at was to shift the yield curve parallel upward by 1%. In this situation, the payment increased to $258 billion, or 2.018%. If this were to occur, the portion of the government to service the debt would rise by almost 38%! Mind you, this is only for a 1% increase while some experts are calling for rates to rise significantly more.

After this flat increase, I looked at a number of proportional increases to the base interest rates. These were 25%, 50% and doubling the rates. A 25% increase resulted in a 6% increase in the financing cost, while 50% was a 13% increase and doubling the rate was a 26% increase. These are all much rosier cases than the flat shift of 1%, however, they too would be quite harmful to the national budget.

Finally I looked at some rather sharp increases. I started this exercise again assuming a parallel shift, this time of 5%. This move almost tripled the cost of financing the national debt to just under $550 billion. Lastly I assumed that all rates would increase by a factor of five. This practically doubled the finance cost to $385 billion.

What I took from this exercise was that any increase in the interest rate on the national debt would be incredibly costly to the US government. The main problem lies in two parts. First, existing rates are incredibly low and there is little place else to go except for upward. With the increases in government spending and the inundation of international debt markets with US debt, it looks increasingly likely that this will happen. Second, the average maturity on US treasury debt is fairly short term at under five years. As such, much of the debt is short term and will be very sensitive to interest rate increases. Additionally, any new debt would also have to be financed at higher rates.

This practice was done to show the true cost of deficit spending. None of the assumptions made in this exercise assume the principle on treasury debt is ever repaid, it is only refinanced indefinitely. As interest rates rise, the government must divert an ever increasing amount of its money to just paying more in interest instead of on social spending or even debt reduction.