In the depths of the great recession, the Federal Reserve (the Fed) chose to push interest rates down by buying massive amounts of Treasury notes and bonds. That tactic was meant to stimulate private sector investment and invigorate demand for additional employees. Unfortunately, holding interest rates very low for 6 years has starved pensions and retirement incomes. Employment levels improved, but wage growth and and labor productivity have been disappointing. Inflation has remained low. During those six years, government spent lavishly, while it had access to extremely cheap debt financing. Interest rates are likely to head higher now and that will have disparate effects on lenders (savers) and borrowers. But, will the rate increases be too little too late?
During 2016, the US government is expected to redeem or refinance $3.451 trillion of notes and bonds, about one-sixth of its total debt. Since the Federal Government has no budget surplus, it will need to replace those old debts with new debts, i.e. conduct a “roll over.” In the first 7 months of 2016, foreign holders, mostly central banks, sold a net $136 billion of their US Treasuries. The rapid pace of sales helped push US bond yields up. At the same time, the Fed has been looking for an opportunity to increase the overnight interest rate, a benchmark that influences other interest rates. It increased the rate by 0.25% in December 2015. The market’s awareness of the Fed’s ongoing intention causes rates to be slightly higher in anticipation of the Fed’s rate hike this September or December.
Issuing bonds with longer maturities instead of short maturities is advantageous, if government believes that long term rates will rise back to historic levels during the life of the new bonds. The verdict depends on specific future rates and time periods. For example, a 2% rate for 20 years is cheaper than paying a 1% rate for 3 years, then rolling over to a note at a 3% rate for 7 years then a 4% bond for 10 years. The modestly higher rate for a longer maturity reduces the interest (coupon) payments that the Federal Government would need to pay over the long run – if rates return to near “normal.” With a national debt near $19 trillion, even small reductions in interest payments are welcomed. For example, if this year’s maturing $3.451 trillion in debt could be rolled over a day before the Fed’s 0.25% hike takes effect, it could save taxpayers $2.2 billion per year.
The notion that government might reduce interest costs by rolling over old Treasury bonds before their maturity will not work. Older, long maturity bonds may have been issued at a yield of 7% but they are now trading at a price higher than when they were issued – a price high enough to create a yield equal to that of a new issued Government note with the same remaining maturity. Owners who bought these old bonds at the time of issue can sell them today for a substantial capital gain or they can hold them until maturity, earning the high coupon rate set at the time of issue. The issuer does not have the same kind of advantage. From an issuer’s viewpoint, there is little advantage to redeeming a bond early unless the bond was issued with a clause allowing its early redemption at a price that is less than the bond’s current market value.
A government with excellent financial conditions will be able to sell new bonds with a low, so-called “risk free” interest rate. That rate will be at a level established by the central bank. In recent months, the 20-year constant maturity rate for Treasury notes is 1.9%, down from 6.9% in January of 2000. A return to the “good old days“ of 7% would be a boon for savers, but a burden on the Federal government, and ultimately on taxpayers.
Investing retirement funds in 4% or 5% securities is an option that evaporated near the onset of the great recession. Since then, chasing a good yield has been a thankless task. For consumers hoping for savings accounts and CD returns that are not laughable, the wait may be long, since the Fed is barely crawling toward higher rates. Furthermore, when the Fed increases rates, there will be an offsetting decreases in the present value of any long term bonds or REITs, which consumers are holding. Government’s interest rate expenses will slowly rise as it rolls over debt at ever-higher interest rates. As always with new leadership in the White House, there will be pressure to embark on aggressive spending sprees. If the Fed quickly hikes rates, closing the cheap money era, those sprees will cost the taxpayer even more.
Segments of retirement portfolios held in cash avoid the risk of capital loss, but they earn nothing. Stock markets performance is as impossible to predict as the whimsy of elected officials. We offer no advice on which allocation of capital will most benefit consumers.
The impossible quest for respectable yields has left a bleak future for many pension funds. Their annual required contributions are often calibrated to an assumption for a 7% long term investment return, as suggested by some actuaries. A return that high has not been readily available from investment grade securities over the latest 6 years. For many pension funds, investment earnings plus contributions now fall short of the required benefit payout, meaning the fund is being sucked dry. Private pension funds (e.g., those of long distance truckers) can adjust by making painful reductions in benefit levels. Unfortunately, some government pension funds are set up to pay generous pensions, but they are blocked by state constitutions from adjusting beneficiary payouts to sustainable levels. For Americans managing their own retirement funds and those in pension funds, the slow recovery in interest rates may be too slow to make satisfying progress in earnings.
The only avenue left for moribund government pensions is a large hike in annual contributions, a public bailout, or a changed state constitution that allows payout adjustments. If a bailout is proposed, it had better be from the level of government that set up and oversaw the failing pension fund. Voters who endured austerity and prudently saved for retirement will show little sympathy for those who chose reckless spending instead of prudence.