Monthly fixed-income focus

What do rising government budget deficits and debt mean for bonds?

What you need to know

• Government budget deficits have widened in recent years, driving Treasury debt to more than $36 trillion.
• Concerns in bond markets could lead to a steeper yield curve and higher volatility, with long-term bonds potentially being more sensitive.
• The U.S. government is unlikely to default, in our view, because it can issue currency to service debt, if needed.

Portfolio tip

Consider adding international investment-grade bonds and emerging-market debt to enhance diversification. Within U.S. investment-grade bonds, we favor seven- to 10-year bonds, which can lock in higher yields for longer than short-term bonds and CDs but may be less sensitive to government debt concerns than long-term bonds.

Widening government budget deficits have driven debt higher

Government budget deficits have widened as spending continues to outpace tax revenue. Federal benefit programs such as Social Security, Medicare and Medicaid represent a large and growing share of the budget.

Millions of Americans rely on these benefits for retirement income and health care, making meaningful cuts challenging and politically unpopular. The aging population means these programs are likely to continue to grow. Shifting more of these costs to states has been explored, though this would likely require states to raise taxes.

While national defense is considered part of discretionary spending, geopolitical tensions make reductions difficult. However, there may be opportunities over time to share more of this burden globally with allies, such as North Atlantic Treaty Organization (NATO) members that recently agreed to increase military spending.

Interest on the federal debt recently surpassed $1 trillion annually and is expected to continue rising, especially as maturing debt is refinanced at higher yields.

The tax and spending bill recently passed by the U.S. House of Representatives would extend tax cuts implemented in 2017. In addition, it would reduce or eliminate income taxes on Social Security income, tips and overtime pay.

Spending cuts and economic growth incentives in the bill would likely be insufficient to offset lower tax revenues. This could potentially drive the deficit higher by nearly $3 trillion over the next decade, according to Congressional Budget Office (CBO) estimates. Tariff revenues could help offset proposed income tax cuts, although trade negotiations and legal challenges to the Trump administration's authority to impose broad tariffs create uncertainty. In addition, elections over the next several years could impact trade policy, making accurate long-term forecasts challenging.

The bill has advanced to the Senate, where it likely faces additional revisions. While the final bill passed into law could differ from its current form, deficits and debt are projected to continue rising, as shown the following chart.

What do rising deficits and debt mean for bonds?

Concerns in bond markets with government deficits and debt could lead to higher yields to compensate for perceived credit risk. Since deficits lead to rising debt over time, long-term bonds may be more sensitive. The result could be a wider difference between long- and short-term yields, known as a steeper yield curve.

In fact, 20- and 30-year Treasury bond yields have risen to near 5% in recent months, roughly 100 basis points (1%) above two-year Treasury note yields. In addition, international investors — including global central banks and financial institutions — have pulled back on purchases of U.S. Treasury securities in recent years for geopolitical reasons and to diversify reserves into other government debt, currencies and gold.

As a result, to absorb debt issuance, a broader group of investors is needed, many of whom tend to be more focused on yields. This trend could drive volatility higher over time, especially for long-term bonds.

To help manage these risks, consider adding international investment-grade bonds and emerging-market debt, if appropriate, to enhance diversification. Within U.S. investment-grade bonds, we favor seven- to 10-year bonds, which can lock in higher yields for longer than short-term bonds and CDs but may be less sensitive to government debt concerns than long-term bonds.

While bond yields and volatility could rise over time, especially for long-term bonds, the U.S. government is unlikely to default, in our view. The U.S. Treasury market remains one of the largest, deepest and most liquid in the world. U.S. investment-grade government bonds offer higher yields than those from most other developed markets, which should continue to attract solid demand from a broad base of investors.

Because U.S. Treasury debt is issued in U.S. dollars, additional currency could be issued to service debt if the burden becomes unsustainable over the long term. This is referred to as debt monetization.

While we don’t expect this to be necessary, larger money supply could lead to a weaker dollar and potentially higher inflation. Notably, higher inflation would likely grow the economy on a nominal basis, generating additional tax revenue that could be used to service debt.

Overall, while difficult decisions would need to be made over time to narrow deficits, we believe the U.S. government has a broad range of options available to manage its growing debt load.