How Rising Corporate and Federal Debt Could Affect Your Investments

If the rapid growth of U.S. borrowing keeps you up at night, you’re not alone.

Even before COVID-19, investors had reason to be concerned about the federal debt, which, after a brief period of decline in the 1990s, has been on a steady upward march for most of the 21st century.

Indeed, the federal debt as a percentage of gross domestic product (GDP) reached 100% in the years following the 2008–2009 financial crisis, and this year’s historic pandemic-relief spending has pushed that number much higher. As of mid-2020, the federal debt stood at 136% of GDP.
 

Awash in debt

This year’s historic pandemic-relief spending caused the already-elevated federal debt to jump by more than 25%.

Source: Charles Schwab and Federal Reserve Bank of St. Louis. Data from 01/01/1990 through 06/30/2020.
 

Emboldened by historically low interest rates, U.S. companies, too, have been on a borrowing binge for the better part of a decade.

Unfortunately, many businesses saw their profits evaporate due to this year’s pandemic, which ushered in a wave of corporate defaults. As of midyear 2020, defaults were rising at the fastest pace since the financial crisis, which could ripple through the broader economy if layoffs continue, suppliers go unpaid, and local and state tax revenues continue to shrink.
 

Going for broke

As the rate of corporate borrowing has risen, so too has the rate of corporate defaults.  

Source: Bloomberg, Federal Reserve, Moody’s Investors Service, and U.S. Bureau of Economic Analysis. Data for nonfinancial corporate debt from 12/31/2007 through 06/30/2020 and data for high-yield corporate defaults from 01/31/2008 through 07/31/2020.
 

“Longer term, we might also see significant ramifications associated with running up the federal debt—including stunted economic output,” says Liz Ann Sonders, Schwab’s chief investment strategist.

Let’s look at why federal and corporate debt matters—and how you might adjust your portfolio in response.

Federal debt

In the near term, the soaring federal debt isn’t a major concern for two reasons:

  1. The Federal Reserve has dramatically lowered the cost of borrowing by reducing the federal funds rate to a range of 0% to 0.25%, down from 2.25% just a year earlier. The fed funds rate influences interest rates on everything from credit cards to U.S. Treasuries, and the lower the rate the less the government has to pay its bondholders in interest.
  2. At least for the time being, the Fed has guaranteed a market for U.S. Treasuries, thereby reducing the yield the government needs to offer to entice outside buyers.

Once the economy recovers, however, the Fed will likely look to raise rates to help stave off inflation. It will also need to pull back on its purchases of Treasuries, which may require the government to pay higher yields to attract traditional big buyers like China.

Over the long run those higher interest payments will eat up more of the federal budget, potentially leading the government to cut back on infrastructure investments and other capital expenditures, which in recent years have contributed about a fifth of U.S. GDP.

“All else being equal, net interest payments over the next 10 years will crowd out government spending elsewhere. And when the government invests less in the economy, growth tends to suffer,” Liz Ann says.

Corporate debt

When the economy is growing, borrowing typically helps businesses expand their production capacity or workforce to meet increasing or anticipated demand. However, many businesses today are turning to the debt markets simply to stay afloat.

“Unfortunately, many companies today aren’t issuing bonds to build new plants or hire new employees—they’re doing so to shore up cash reserves, which can help them weather future economic uncertainty,” says Collin Martin, managing director and fixed income strategist at the Schwab Center for Financial Research. “As a result, their future growth could be constrained as debt payments crowd out more productive investments, just as with the federal government. It might even make them riskier as they pile on debt in the face of declining profits and weaker economic prospects.”

So far, moves by the Fed to backstop that debt by purchasing corporate bonds have helped sustain demand and provided fresh capital—which has eased investors’ fears and helps to explain why stock prices have continued to rise even as other economic indicators have tanked.

However, there’s a limit to the amount of corporate bonds even the Fed can buy. For example, relatively few individual sub-investment-grade corporate bonds are eligible for purchase by the Fed due to its self-imposed ratings limitations. “Ultimately, the Fed can’t save everyone,” Collin says.

What to do

High levels of federal and corporate debt could impact the near- and long-term outlook of mainstay asset classes such as stocks and bonds. With that in mind, here are some moves that could help fortify three key areas of your portfolio:

  • Bonds: With corporate debt balances at record levels and bankruptcies on the rise, there’s greater risk that defaults will increase in frequency. Despite the Fed’s support for the credit markets, that support can’t keep every company afloat; nor will it last forever. For now, a conservative approach may make sense for many investors. In particular:
    • Avoid overexposure to junk-rated corporate and municipal bonds, as well as those on the lowest rungs of the investment-grade scale. Focus instead on more defensive issuers with lower debt balances or revenue streams that can weather the ups and downs of the recovery
    • Limit the average duration of your bond funds. While not an immediate concern, keeping the average duration of bond funds in your portfolio below market benchmarks can help you manage the effects of interest rate risk, or the chances that your holdings will lose value should rates rise.For example, the Bloomberg Barclays Aggregate Bond Index, which is typically used as a proxy for the overall U.S. bond market, has a duration of about 6, so we would suggest keeping the average duration of your U.S. bond funds at 4 or 5.
  • Cash savings:The Fed has pledged to keep short-term rates near zero for the foreseeable future. That means yields on cash or short-term investments like certificates of deposit and money market funds are likely going to remain quite low. As a result:
    • If you’re still working, consider limiting your cash savings to emergency funds that can cover three to six months’ worth of expenses and investing the rest in a diversified mix of assets.
    • If you’re a retiree, consider limiting your short-term cash reserves to what you’re going to need for the next two to three years, and investing the rest in higher-income options such as annuities, bonds, and dividend-paying stocks.
  • Stocks:The early days of the pandemic led to significantly elevated volatility and the fastest 30% stock market decline in history. Thanks in part to the Fed’s aforementioned relief efforts, stocks’ recovery was nearly as swift. Even so, the speed with which a full market cycle of decline and recovery unfolded serves as a reminder that what’s gone up might well go down again. Thus, rather than trying to anticipate market moves, consider:
    • Rebalancing your portfolio more frequently, especially after big swings (as opposed to the typical calendar-based portfolio maintenance that brings your asset allocations back in line with your long-term targets).
    • Focusing on quality. In the wake of a recession, investors often focus on sectors that look primed for a rebound. However, Liz Ann says it might be better to focus on so-called quality stocks. “You want to look for industry leaders with strong balance sheets, positive cash flows, and management teams that will see them through this crisis,” she says.
    • Reducing your expectations for long-term stock returns and increasing your savings to make up for the difference. For example, Schwab estimates the annual return for U.S. large-cap stocks over the next decade will be 7.1%—compared with 10.1% for the five decades prior.
       

Take control

Investors are right to be concerned about historically elevated debt levels and their effect on the economy. “You may have to put more away if you were counting on a repeat performance from the markets to help you reach your long-term goals,” Liz Ann says. “But with some planning, you can reposition your portfolio to help weather uncertainty.”

Next Steps

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Investing involves risk, including loss of principal.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when a nonretirement account is rebalanced, taxable events may be created that may affect your tax liability.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.

Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research, and are developed through analysis of historical public data.

Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.