I’ve been talking about the economy and the markets in Chicago, Jacksonville, Philadelphia and a few other cities during the first weeks of 2013, and almost every investor I’ve met wants one question answered:  What’s going on with interest rates?

I understand why bonds, and not the rally in equities, are the pressing topic. We’ve been in a bull market for bonds for more than 30 years now, and investors have poured hundreds of billions of dollars into bond mutual funds. But now that the 10-Year Treasury yield is back above the psychologically-important 2% mark, many investors are contemplating the potential ramifications of a rising interest rate environment. I believe we’re at the beginning of a great rotation out of bonds and into stocks; the recent fund flows into equity funds and a coincident selloff in treasuries are evidence that I’m not alone in my belief. I believe rising rates are going to impact investor portfolios and, more broadly, the nation’s debt picture.

So how high will rates climb?

Historically, the 10-Year U.S. Treasury rate has tracked the nominal growth rate of the U.S. economy.  Going back to 1962, there is only a 31 basis point average spread between the 10-Year Treasury rate and the smoothed annual growth rate in U.S. nominal Gross Domestic Product (GDP).¹ At the moment, the yield on the 10-Year U.S. Treasury rate (the green line below) stands at roughly 2%.  The smoothed nominal GDP (the blue line) is about 2.75%.  A convergence between the two could potentially lead to a 50-100 basis points back up in treasury yields. Rates could go even higher if the nation’s economic growth accelerates.

Source: Bloomberg as of 12/31/12.

What will rising rates mean for our portfolios?

The current breakdown of mutual fund assets suggests that of investors’ fixed income allocations, more than 60% is in government-related securities represented by the Barclays Capital U.S. Aggregate Bond Index.² The Barclays Capital U.S. Aggregate Bond Index has a current yield to maturity of 1.91% and duration of 5.20 years.³ If rates were to rise 1% over the next 12 months, all else being equal, the Barclays Capital U.S. Aggregate Bond Index would likely return -3.29%.  That doesn’t tell the whole story, however. The timing for the ultimate day of reckoning is unknown but even a little bit of selling would create plenty of supply.  With just a little panic, treasury investors could all be left trying to get out of the door at the exact same time.   

Source of chart data: Barclays Live as of 1/31/13. Chart is for illustrative purposes only and is not meant to predict or depict the performance of any security. Hypothetical returns for the Barclays Aggregate Bond Index are based on the current yield to maturity of 1.91%, the current duration of 5.2 years. The Barclays Capital U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any fund. Past performance does not guarantee future results.

What will rising interest rates mean for the nation’s debt picture?

It all depends on why interest rates are rising. The nation might be in for some trouble if rates are moving higher because of a failed U.S. Treasury auction. But it might not be particularly costly if rates are rising as the economy is growing.

Let’s start with the facts. 

• The U.S. Government has $16.4 trillion in debt outstanding with 70% of it held by the public (the remainder is held by government trust funds like the Social Security and Medicare trust funds)⁴
• The federal government’s interest expense in 2012 was over $400 billion⁵
• The Congressional Budget Office estimates that the U.S. Government will need to issue approximately $7.4 trillion in new debt over the next four years (the figure includes new debt to fund the federal government plus the refinancing of existing debt set to mature over the next four years), while still servicing the fixed interest burden on the existing debt
• A one-time 1% increase in the 5-Year Treasury rate today, all else being equal, would add approximately $74 billion ($7.4 trillion times 1%) in interest expenses to the federal government over the next four years.  This represents a nearly 20% increase in the interest burden

Another $74 billion sounds like a lot of money. But if rates were rising because of improving economic activity, the amount the nation is paying in taxes would likely go up.  As the chart below shows, the federal government has collected, on average, 17.8% of the nation’s GDP in tax receipts each year. Today’s tax receipts, with the economy still suffering a hangover from the Great Recession, are only at 15.8% of GDP.  If tax receipts as a percentage of GDP were to simply revert to the mean, Uncle Sam would collect an additional $320 billion per year in its coffers (assuming a $16 trillion economy). That amount would more than offset the hypothetical rise in debt service.

Source: National Bureau of Economic Research, Bureau of Economic Analysis and Haver Analytics as of 12/31/12.

1. Bloomberg, OppenheimerFunds Proprietary Research, as of 12/31/12. 
2. Lipper Analytics, OppenheimerFunds Proprietary Research, as of 12/31/12.
3. Barclays Live, as of 1/31/13.
4. U.S. Treasury, as of 12/31/12. 
5. U.S. Treasury, as of 12/31/12.

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