Debt elephant needs an urgent diet

It isn’t just a normal elephant in the room, swinging its tail and smashing things, and stomping on things it doesn’t quite see as it manoeuvres in a confined space with which it’s not familiar.

Because this plump pachyderm is growing by the hour.

It’s the US national debt, now surpassing US$36 trillion, and counting – growing faster than the US economy. By 2034, according to the Congressional Budget Office (CBO), the national debt will have ballooned by 52 per cent, to US$55 trillion – enough to take the US’ ratio of debt-to-GDP above the nation’s all-time high of 106 per cent, reached in 1946 after World War II.

The US government brings in about US$5 trillion a year in total revenue: more than one-quarter of that – US$1.1 trillion in 2024, according to Federal Reserve Bank of St. Louis data, almost double the amount it was paying five years ago – goes back out the door in interest payments on its debt. The nation now spends more on interest payments than it does on defence.

It’s been a bipartisan problem: the big grey houseguest has taken decades to swell, and keepers from both sides of the US political aisle have repeatedly feigned concern at its growing girth, without putting the animal on any form of diet. But the recent uptick in interest rates to their highest levels in more than two decades means the cost of feeding the giant metaphor is becoming untenable – and not just for the borrower.

Now, the so-called “One Big, Beautiful Bill” will, over a decade, add another $US3.3 trillion to the debt, according to the independent Congressional Budget Office. 

A recent paper from Apostle Funds Management argues that the strain on global markets is intensifying, as Washington’s escalating debt burden pushes the global financial system to its limits.

“As the US enters a new era of high interest rates, investors must confront the harsh reality of America’s debt addiction – one that threatens to destabilise bond markets, upend traditional diversification and trigger global contagion,” says Joe Unwin, head of portfolio management at Apostle.

The US fiscal situation is alarming, but investors also should factor-in the resilience of the US economy, the depth of its capital markets and the country’s sheer capacity for innovation. And as always, volatility can create opportunities for active investors.

But while no-one – least of all, Apostle – is writing the US off as a receding economy, there are three key structural risks that loom large on the horizon, says Unwin:

• Bond market instability poses a fundamental risk to fixed-income security.
• Fiscal strains are upending traditional market correlations and reshaping diversification.
• Rising US yields are sending shockwaves through global markets, and could result in a liquidity crunch.

On the first point, says Unwin, the US bond market – long considered the bedrock of global financial stability – is becoming increasingly fragile. To finance rising debt, the Treasury must issue more bonds at higher yields. This places upward pressure on interest rates across the economy and raises the risk of a liquidity crunch.

A sharp spike in yields can trigger a mass exodus from fixed-income markets, as evidenced during the 2020 “dash for cash” – triggered by the COVID-19 pandemic – in which investors dumped any assets they could to raise cash, leading the 10-year Treasury yield to more than double in a week. Long-term bondholders suffered significant losses, and investment-grade markets experienced historic outflows.

“To safeguard against such volatility, investors should prioritise assets with strong cash flows and low debt exposure, and consider inflation-protected securities as a hedge against rising borrowing costs,” says Unwin.

The increasing girth of the US debt elephant is also eroding diversification and market correlations.

“The traditional negative correlation between stocks and bonds has broken down in the high-rate environment. Both asset classes are now moving in tandem, reducing the effectiveness of diversification strategies,” says Unwin.

This shift is partly due to the Federal Reserve’s manipulation of interest rates to manage fiscal imbalances, which distorts natural market signals and undermines investor confidence, says Apostle. As corporate earnings weaken under higher borrowing costs, the risk of defaults rises and credit spreads widen. At the same time, equity valuations fall, creating a synchronised downturn that leaves few safe havens.

Since the pandemic, this structural change has become increasingly evident, with stock-bond correlations reaching levels unseen in 75 years. In response, investors are reallocating capital to defensive sectors such as healthcare, utilities, and consumer staples – industries less sensitive to interest rate movements. Alternative investments are also gaining favour as new diversification tools.

And the US debt crisis is only going to get worse, says Unwin, as the Trump administration grapples with the real-world contradictions of its policy platform. The tariff plans do not appear to be on track to raise the targeted revenue and the so-called ‘One Big Beautiful Bill’ will increase both the deficit and the debt.

“The issue for the White House is that even though they want short-term rates to come down, the US Treasury market is adding a bit more term premium back into the yield curve, which it hasn’t really had for a few years, which means, ultimately, they borrow from the Treasury market rather than from the Fed,” says Unwin. “The issue they have is that they’ve got policies that require more debt, but the bond market is increasing treasury yields in response to those policies, so not only are they not doing themselves any favours in terms of having to issue more debt, but also, they have policies that mean they’re going to be paying more interest on their debt.”

Unfortunately, the US fiscal imbalance is not just a domestic concern. The global economy is not only sneezing at America’s cold, it is at risk of major respiratory trauma.

“Rising Treasury yields attract global capital, diverting funds from foreign markets and triggering currency depreciation and inflationary pressure abroad,” says Unwin. “Nations heavily exposed to US-dollar-denominated debt – such as Japan, China, and the UK – are particularly vulnerable. To stabilise their currencies, these countries may be forced to hike interest rates, risking domestic recessions.’

Australia, with its commodity-driven economy and banking sector reliant on global credit markets, is especially at risk. “Higher US yields could place upward pressure on Australian interest rates, increasing refinancing costs and tightening credit conditions,” he says.

To navigate this environment, Apostle says investors should consider allocating capital to sectors that historically perform well during high-rate periods, including energy, infrastructure, and US-based multinationals with dollar-denominated revenues. US financials and defence companies also provide relative insulation from currency fluctuations. Apostle also thinks that alternative lenders and private credit markets offer attractive opportunities amid tightening bank lending standards.

“We think floating-rate debt will look more attractive, purely because it doesn’t have the interest-rate sensitivity that fixed-rate debt does,” says Unwin. “Income-oriented investors are likely to look at floating rate corporate bonds, but then in high yield, there’s bank loans and private credit, where the vast majority is floating-rate as well.”

Investors have mostly been attracted to private credit because it offers higher returns, but Unwin suspects more will opt for private credit for “the kind of stable yield that they maybe don’t want to get from bond markets.” But the big challenge for investors remains trying to find diversification in private credit.

“You need to try and diversify, particularly in a market like Australia, which is a pretty concentrated private credit market,” he says. “While one of the themes in markets this year is diversifying away from the US, when it comes to private credit, the US just has a far more sophisticated market than anywhere else. We mainly focus on the ‘mid-market’ in the US, which typically refers to companies with US$25 million to US$250 million in EBITDA. With US$10 trillion in revenue, the US mid-market makes up nearly one-third of all US private sector GDP; if the US mid-market were its own economy, it would be the fifth-largest in the world.

Apostle is also investing in real estate debt in the US. “We like that because commercial real estate in the US in the last two to three years has not seen a lot of capital flooding-in, as we’ve seen in Australia. So, the opportunity isn’t as watered-down.” The firm is also “exploring opportunities” in Europe: “We like European credit more generally because it tends to offer a bit of a yield premium over the US, but we’re still exploring the private credit market over there, says Unwin.

James Dunn

James is an experienced senior journalist and editor of The Inside Network's publications.