Government debt is usually discussed as a question of public finances. How much is a country borrowing? How large is its deficit? And at what point does its debt become difficult to sustain?
For investors, the issue goes considerably further.
Governments are among the world’s largest borrowers, and the amount of debt they issue can influence yields, interest rates and the availability of capital elsewhere in the financial system. That makes the recent rise in national debt difficult for markets to ignore.
Global gross public debt has climbed from 59% of GDP in 2007 to around 95% today, equivalent to approximately $110tn. In the US alone, government debt has now surpassed $40tn, up by around $3tn over the past year.
The numbers are striking, and their significance for investors goes well beyond sheer size.
Governments need investors too
Every new government bond ultimately needs a buyer. That might be a pension fund, insurance company, bank, investment manager, overseas institution or individual investor. When governments increase borrowing substantially, financial markets are being asked to absorb more sovereign debt.
The price at which investors are willing to do that matters.
For much of the period following the financial crisis, governments in developed economies were able to borrow at exceptionally low rates. That environment has changed, with higher yields making new borrowing more expensive. They can also increase refinancing costs as bonds issued when rates were much lower reach maturity.
The US illustrates the scale involved, with total federal debt now passing $40tn. Debt held by the public – broadly, Treasury debt held outside federal government accounts – exceeds $32tn. The Congressional Budget Office projects that this measure could reach 120% of GDP by 2036.
As the stock of debt grows, the interest bill can become a larger share of the fiscal calculation, particularly as lower-cost borrowing matures and is refinanced at higher rates.
Sovereign yields influence far more than government borrowing
Government bond markets occupy a central position within financial markets because sovereign yields provide reference points against which many other assets are assessed. When the yield available from government debt rises, the calculation facing investors changes.
A corporate borrower, for example, generally needs to offer investors a premium over government bonds to compensate for additional credit risk. Higher sovereign yields can therefore contribute to a higher cost of financing elsewhere.
The effect can extend into equity markets. When relatively low-risk assets offer more meaningful returns, investors may demand greater prospective returns before committing capital to riskier investments.
Capital does not simply move from equities or corporate bonds into government debt whenever yields rise. Markets are far more complicated than that: what changes is the starting point from which investment opportunities are compared.
A world in which government bonds yield very little presents investors with a different set of choices from one in which sovereign debt itself offers potentially attractive returns.
The headline debt figure only tells part of the story
Comparing countries simply by the size of their national debts can be misleading. The sustainability of government borrowing depends on a much wider range of factors.
The size and growth of the economy matter, alongside the interest rate being paid, the maturity profile of existing borrowing and the government’s ability to raise revenue. The depth of a country’s capital markets can also be important, as can the composition of its investor base and the currency in which it borrows.
Two countries with similar debt-to-GDP ratios may therefore face very different financing conditions.
Markets consequently pay attention to the direction of fiscal policy and the credibility of future plans as well as the headline level of borrowing. Investors need confidence that governments can continue financing themselves on acceptable terms.
More sovereign debt changes the competition for capital
There is another consequence for markets if governments, companies and other borrowers are all seeking capital. When sovereign issuers require substantially more funding, investors have more government securities from which to choose. If those securities also offer higher yields, other investments are being measured against a more demanding benchmark.
That can influence decisions throughout capital markets: how companies finance expansion, whether projects generate sufficient returns to justify investment, how portfolios are constructed and what investors are prepared to pay for assets.
Demand for government debt remains strong, and investors hold sovereign bonds for many different reasons, including income, capital preservation, liquidity and regulatory requirements. Even so, the scale and price of government borrowing increasingly form part of the environment in which other capital-allocation decisions are made.
Debt is becoming a market story
National debt will always be a political and economic issue. Investors, however, have a different question to consider: what happens as governments ask capital markets to finance increasingly large amounts of it?
The answer will vary from country to country.
Some governments have stronger fiscal positions than others, while some benefit from deeper domestic capital markets, longer debt maturities or greater capacity to absorb higher financing costs. Those differences matter when investors assess sovereign risk and opportunity, but there is a broader change taking place.
Government borrowing is becoming harder to regard simply as background to what happens elsewhere in financial markets. The volume of debt being issued, the yields required to attract buyers and the cost of refinancing existing obligations increasingly feed into the price of capital.
Once the price of government capital changes, the effects rarely stop with governments.