Government debt and what it means for investors

Government debt levels generate consistent alarm and specific consequences, and separating the two is useful for anyone holding bonds.

What the numbers mean

The measures.

Debt is generally expressed as a percentage of annual output, which allows comparison between countries and over time.

The deficit is the annual shortfall between spending and revenue, which adds to the debt.

Interest cost as a share of revenue is arguably more informative than the debt level itself, since it measures the actual burden.

And the maturity profile matters: debt that must be refinanced soon is more sensitive to rate changes than long-dated debt.

Why the level alone tells you little

Several factors.

The currency of issuance: a government borrowing in its own currency with a central bank cannot be forced into default in the same way as one borrowing in a foreign currency, which is the crucial distinction.

Who holds the debt: domestic versus foreign holders behave differently.

Growth relative to interest rates: if growth exceeds the interest rate, debt ratios can fall without a surplus.

Institutional credibility and the depth of domestic markets.

And the maturity profile.

Which is why countries with similar debt ratios can face entirely different market conditions.

The mechanisms that matter

How debt concerns transmit to markets.

Rising yields, as investors demand more compensation, which raises borrowing costs throughout the economy and reduces existing bond prices.

Currency effects, where fiscal concerns produce currency weakness.

Crowding out, where government borrowing raises the cost of capital for private borrowers.

Constraints on future policy, where high interest costs limit spending options.

And, in extreme cases, inflation as an implicit means of reducing the real value of debt.

What actually happens

Historically.

Outright default on domestic-currency debt by developed economies is rare.

Debt burdens have been reduced historically through combinations of growth, inflation, financial repression — holding rates below inflation — and fiscal adjustment.

Which means the more likely outcomes for holders of such debt are low real returns and inflation rather than default.

Emerging market debt in foreign currency is a different case, where defaults and restructurings have occurred repeatedly.

The implications for a portfolio

Narrower than the coverage suggests.

Holders of long-dated government bonds are exposed to rising yields, which produces capital losses.

Which is an argument for duration appropriate to the horizon rather than for avoiding government bonds.

Inflation-linked bonds provide protection against the inflation channel specifically.

Diversification across currencies and issuers reduces exposure to any single fiscal position.

And equities have some inflation protection over long periods, though not reliably in the short term.

What not to do

The overreactions.

Abandoning bonds entirely, which removes the diversification against growth shocks that they still provide.

Holding only cash, which is exposed to the inflation channel most directly.

Buying gold or commodities heavily on the basis of a fiscal narrative, which has been a recurring recommendation for decades with mixed results.

And restructuring a portfolio based on a fiscal forecast, which is subject to the same forecasting problems as any other.

The market's view

Which is observable.

Bond yields reflect market expectations of inflation, growth, policy rates and credit risk, continuously.

Which means concerns about a government's fiscal position are already reflected in the price of its debt, to the extent the market perceives them.

Acting on a fiscal narrative that is widely discussed is acting on information already priced.

Where markets have repriced sharply — as has occurred following unexpected fiscal announcements in several countries — the move happens within hours, which is not actionable.

The genuinely useful observations

For an individual.

Higher government borrowing costs feed into mortgage rates, which affects households directly.

Fiscal pressure affects future tax policy and public service provision, which affects long-term planning.

Pension and benefit provision may be adjusted, which affects retirement planning.

And inflation risk is a genuine consideration for anyone holding long-dated fixed nominal income.

These are more useful than any portfolio positioning based on a fiscal view.

The reasonable position

Which is unexciting.

Hold a diversified portfolio across currencies, issuers and asset classes.

Match bond duration to horizon.

Consider inflation-linked instruments for long-dated real liabilities.

Do not restructure based on fiscal narratives.

And recognise that the outcomes such narratives predict have been predicted continuously for decades, with variable results.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.