Uncle Sam Wants You. . .to Buy Treasury Bonds

The U.S. Treasury has an unenviable job: It has to find buyers for trillions of dollars in new bonds that are sold to fund each year's federal deficit and replace maturing bonds. It hopes average citizens will pony up and invest hundreds of billions of dollars in newly issued bonds, but that might not be a winning investment for you.

With deficits climbing from $455 billion in 2008 to $1.42 trillion in 2009, $1.3 trillion in 2010 and an estimated $1.5 trillion in 2011, the Treasury's task has become even more challenging.

For context, the current debt owed to "the public" -- which includes foreign bond owners -- and to other federal agencies such as the Social Security Trust Funds, is by the Treasury's own reckoning $14.1 trillion. That's roughly equal to the nation's GDP of about $14.5 trillion.

Even if we discount the interest owed to Social Security, that still leaves more than $9.5 trillion on which interest must be paid every year. According to the Treasury, the interest paid in 2010 was $413 billion. In one of the few positives to this tale, the interest paid on America's external debt did decline to $164 billion in 2010 from $189 billion in 2009 as interest rates fell to historic lows.

This isn't chicken feed, however. The interest paid on the external debt is nearly equal to the budgets of the Department of Veterans Affairs ($52 billion), Housing and Urban Development ($47 billion) and Transportation ($71 billion).

The Treasury's Office of Debt Management recently issued a report outlining the Treasury's plans to find buyers for all those bonds. But it faces a number of fundamental problems.

1. The Treasury' projections of future deficits are grossly underestimated. The report's three estimates for the federal deficit in 2012 -- from primary dealers, the Congressional Budget Office and the Office of Management and Budget -- range from $911 billion to $1.1 trillion. Yet other reports from the Obama administration project that the 2012 deficit will reach $1.6 trillion.

This sort of low-balling of future deficits weakens the credibility of the Treasury's report, and suggests that the amount of bonds it must sell will be far greater than presented.

2. Today's historically low interest rates won't last forever. Right now, the yield on a one-year Treasury bond is a meager 0.27%, and the yield on a three-year bond is a modest 1.04%.

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Given that inflation is, by some authoritative estimates, running at about 2.5% in the U.S., and double that in other major economies such as China, investors in those three-year bonds are losing capital every year they hold them.

Rising inflation isn't a flash in pan, either: Wholesale prices are increasing, which guarantees future price jumps in retail goods.

How long can the Treasury find buyers who willing to lose money on U.S. bonds? Probably not long. That may be why the yields on long-term Treasurys have been climbing steadily in recent months. The yield on the 30-year bond, for example, has risen from 3.71% last October to 4.75% this month -- a jump of 27% in less than a year.

3. If the Treasury has to pay higher interest to entice buyers, it will. At that point, the interest paid by the federal government will rise sharply.

The Treasury already estimates interest payments will reach $800 billion by 2020 -- and that's assuming rates stay at rock-bottom levels.

Higher interest payments will inevitably crowd out other federal spending. If we set aside the overly rosy forecasts and assume a structural deficit of $1.5 trillion annually for the next four years, then by 2015, the national debt will be over $20 trillion, and the external debt will be over $15 trillion. Even at a modest average yield of 5%, the interest on that $15 trillion would be $750 billion a year, dwarfing both of the government's biggest programs, Social Security ($695 billion) and the Department of Defense ($663 billion).

4. The Treasury remains dependent on foreign buyers. While the Federal Reserve's $600 billion quantitative easing program of buying Treasurys, known as QE2, has boosted the Fed's bond holdings above those of China (the Fed holds over $1 trillion compared to China's $877 billion), as this chart depicts, the Treasury still depends heavily on foreign buyers.

Should foreign buyers balk at today's low yields, the Treasury would have to raise interest rates to lure them back. Counting on the Federal Reserve to snap up another trillion or two of Treasurys is also an iffy proposition because some Fed board members are already talking about trimming the purchases of U.S.bonds. The QE2 program is slated to end this June.

5. There's heavy competition from other governments issuing their own sovereign debt. Developed nations around the globe are issuing unprecedented quantities of new bonds to fund their deficits. The Bank of International Settlements issued a report last year, The future of public debt: prospects and implications, which outlined the extraordinary demands that government borrowing will place on the global bond markets. The report also noted that interest rates are rising globally in response to heavy sales of sovereign debt.

U.S. Treasurys, in other words, will have to compete with many other nations' debt for buyers. And as populations age around the world, the Bank of International Settlements expects government deficits to skyrocket. Given the trillions of dollars in new bonds governments will be issuing globally, it doesn't take much imagination to foresee a world in which rates could rise far more rapidly than the Treasury currently expects.

The Solution Is You

The Treasury's answer to its need for future buyers is to turn to potential domestic purchasers: banks, pension funds and you, the so-called retail buyer of U.S. bonds. The Treasury is hoping to sell American citizens some $337 billion in new bonds over the next few years, along with $525 billion to insurers and pension funds and a whopping $1.675 trillion to banks.

Would it be wise for investors to buy bonds yielding 1% when inflation is clipping along at 2.5%? Can pension funds and insurers meet their future obligations by earning 1% or 2%? Is it wise to gamble on future inflation being tame by buying long-term bonds? If inflation rises, the market value of those bonds would drop significantly.

All in all, the Treasury seems to be grossly underestimating future deficits, future inflation, future competition in the debt market from other governments, the possibility that foreigners will no longer be big buyers of U.S. debt and the willingness of potential domestic investors to ignore these critical issues.