Debt, GDP, Interest Rate Shock

October 24, 2016

Business Insider has compiled a colorful depiction of the largest debtor countries in the world. Here is the link:

Does debt to GDP mean anything? The answer is maybe. And perhaps the second part of that answer is that it means a huge economic burden if there is intent to pay the debt back.

Mostly, governments never pay back.  They continually refinance (roll over maturities) and add to their debt until some type of market forces impair their market access.  Nonpayment usually means a default, lack of more market access and then a period of negotiation that may take years before it leads to a settlement. Argentina is a recent example; it now has market access following a negotiated settlement of outstanding debt and the installation of a new government.  Other case studies in progress include Greece.  Detroit was prior to bankruptcy and may still be one.  Atlantic City NJ is on the edge.  Puerto Rico is in the midst of this process now, and it will probably take a few years to sort it all out.  Illinois is starting to look like a candidate for this process.

So let’s look at this tradeoff between the issuers of debt, as in governments, and the holders of that debt, as in lenders who are not of the same government. This is where the list at Business Insider provides a starting point.

Some anecdotes are helpful. Italy ranks high on the debtor list. And it has dysfunctional politics and a maligned and questionable banking system. Yet it just issued over $5.6 billion (US dollar equivalent of a euro-denominated bond) with a half century to maturity. The interest rate was 2.85%. That yield was a cheap loan for the government of Italy. But it placed the bond buyer at terrible risk. Only because of the interest rate policy of the European Central Bank was Italy able to achieve such low-cost financing. At Cumberland, we are loath to buy such a bond. But in Europe there are institutions that are required to own sovereign debt, and thus this bond became part of the portfolio.

Is such a holding a disaster in the making? We think the ultimate answer is probably yes. When? There is no way to know.

Consider the report of a special panel at the Ministry of Finance in Japan. We must offer many thanks to Jeff Usher, who writes the Japan Insider report and gave us a heads-up on this report item.

The MoF calculates that a 1% increase in Japanese interest rates would trigger a huge capital loss for Japanese banks and financial institutions holding Japanese government debt. The estimates suggest that a 1% shock, if marked to the market, would result in a loss equal to 13.5% of Japan’s GDP. Note that Japan is at the top of the Business Insider list.

When the Japanese government did this study, they also examined other countries. Jeff Usher reports that the MoF calculated a loss of 4.3% of GDP for a 1% rise in US Treasury yields.

Germany is a lower debt-to-GDP country. Its risk of a 1% shock is 2.5% of GDP. France’s would be 5.2%. Note that in the UK, the loss would be about the same percentage of GDP as in Japan. The Brits would be exposed at 13.3%.

So what does this mean for investors?

First it demonstrates what duration risk is all about. When the issuers of government debt use very low interest rates to finance themselves for a very long time, they transfer risk to the buyers and holders of that debt. Duration is how we attempt to measure that risk. The debt-to-GDP ratio is another way to estimate the risk.

But governments have the power to alter the rules. And they define the accounting systems, so in cases like this they usually don’t mark to market. This is true at all levels of government. State and local governments in the United States do not mark to market on their balance sheets. Like most central banks, The Federal Reserve does not mark to market.

That is an asymmetry, since the investor or holder of debt must look at the market value, either officially or unofficially in some cases. Why? Because that investor may have to liquidate before the final maturity!

And when the maturity is half a century away, the forced liquidation risk becomes dramatic if and when interest rates rise.

At Cumberland we calculate duration all the time, and we shock the portfolios of our clients for changes in interest rates, up or down. Right now we are shortening portfolio durations, as we have been doing for months. We see the asymmetry, and we want to protect clients from it. We think that interest rates in US dollar debt are headed higher. And depending on the outcome of this election, the amount of debt issuance may rise relative to GDP. Regardless of who wins, it is unlikely to decline.

Many thanks again to Jeff Usher of Japan Insider and to Business Insider for data.


The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

The preceding is a commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at

Follow Cumberland Advisors on Twitter at @CumberlandADV.

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