Tag Archives: Debt

09.30.26
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Is AI Investment Reaching A Natural Limit?

By: Russ Kamp, CEO, Ryan ALM, Inc.

I’ve been spending a lot of time recently thinking about the incredible amount of capital being thrown at Artificial Intelligence (AI). There is no question that AI has the potential to dramatically change how we live and work. But does that mean that every dollar being invested in AI infrastructure is going to generate an acceptable return? I’m not so sure. As interest rates continue to rise, I think investors need to start asking a different question. Instead of asking, “How big can AI become?”, perhaps we should be asking, “How much AI capacity can actually be built economically?”

AI investment is staggering. Microsoft, Amazon, Alphabet/Google, Meta, and Oracle (the Hyperscalers) are at the center of this massive infrastructure buildout. Until recently, these companies generated so much cash that they could fund most of their capital spending internally. That situation is changing rapidly. AI-related capital expenditures are consuming an enormous percentage of their operating cash flow, and the hyperscalers are increasingly turning to the bond market and other forms of financing to keep the spending machine going. Four of the five major hyperscalers have issued significant amounts of bonds in 2026, with Microsoft being the notable exception. Collectively, hyperscaler borrowing has already reached roughly $200–$220 billion this year. Wow!

Why should we care? Because the cost of money matters and this massive investment could profoundly impact equities, bonds, real estate, private equity, private credit, etc. DB Pension plans need to take notice! When Treasury yields were 1%-2%, financing massive data centers and other AI infrastructure was relatively inexpensive. Today, Treasury yields have climbed above 5%, and the 30-year Treasury bond is closing in on 5.7%, while some long-term hyperscaler debt is being issued at 6% or more. Oracle has recently  issued long-dated debt carrying coupons approaching 8%. This reality changes the economics dramatically. It isn’t enough for a $10 billion or $20 billion AI project to generate revenue. It needs to generate a return sufficient to compensate investors for the cost of the capital, operating expenses, electricity, depreciation, technological obsolescence, and the risk associated with the project. What is that return likely to be and where is that return going to come from?

Capital isn’t the only potential constraint. AI requires enormous amounts of electricity, generation capacity, transmission, transformers, land, cooling, water, semiconductors, construction, and, of course, data centers. A large AI campus can require hundreds of megawatts of electricity. High-density data centers can cost roughly $14-$16 million per megawatt, meaning that a 500 MW facility could cost approximately $7.5 billion to construct before considering the broader power infrastructure necessary to support it. We keep hearing about seemingly unlimited demand for AI. Fine! But there certainly isn’t unlimited electricity, grid capacity, construction capability, or CAPITAL. Why does the investment community seem to assume otherwise?

Furthermore, the AI trade may be creating its own headwind. Think about this for a minute. Massive AI capital expenditures consumed free cash flow from most of the hyperscalers. Declining or exhausted free cash flow creates a need for external financing. Greater borrowing produces more corporate bond supply. More bond supply can contribute to higher yields and wider credit spreads. Higher financing costs increase the hurdle rate on the next AI project. Eventually, some projects simply won’t make economic sense. That seems like the beginning of a vicious cycle to me.

As mentioned previously, the implications extend well beyond technology stocks. Equity investors need to determine whether these enormous capital expenditures are actually producing an acceptable return on invested capital. Bond investors are being asked to absorb hundreds of billions of dollars of new AI-related debt and need to be compensated appropriately. Real estate investors financing data centers must compete against a >5% risk-free Treasury yield while dealing with higher construction and financing costs. 

I’m certainly not suggesting that the AI boom is about to end. But I do believe that the AI investment thesis may be entering a very different phase. The first phase was about AI models, semiconductors, hyperscalers, and data centers. The next phase may increasingly be about the scarce resources necessary to support all of that growth, beginning with capital and including electricity, generation, transmission, transformers, cooling, powered land and water. The winners may ultimately be those controlling the scarce resources rather than simply those spending the most money.

Markets have an interesting habit of believing that trends can continue indefinitely. From my 45-years in the investment industry, I’ve come to appreciate that they don’t. There is always a natural capacity to every investment. AI will prove to be no different. At today’s cost of capital, the important question isn’t how much AI infrastructure companies want to build. It is how much they can afford to build while still generating an acceptable return. Are today’s investors and pension plans adequately considering that distinction? I’m not convinced that they are.

I have an idea. While you wait for the AI thesis to play out, buy time (extend the investing horizon) by creating a cash flow matching (CFM) portfolio that will secure the monthly benefits and expenses for some time – say 10-years. This will enable that AI thesis to perhaps generate the desired return while it grows unencumbered.

08.21.26
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When is $2T Really Not $2T?

By: Russ Kamp, CEO, Ryan ALM, Inc.

In 2021, the U.S. ran a deficit of $2.772 trillion. We know that much of the stimulus created by that deficit spending was in reaction to the economic disruption created by Covid-19. Fast forward 5-years, and the 2026 fiscal year (10/1/25-9/30/26) federal deficit is projected to be around $1.9 trillion. That is potentially a lot of stimulus provided to the private sector through the U.S.’s deficit spending. But is this nearly $2 trillion in “stimulus” really creating $2 trillion in demand for goods and services and will it create similar consequences to what we witnessed in 2022 when inflation spiked? I don’t think so.

First, 2021’s stimulus was also accompanied by supply factors, as the economy was effectively “shut down” compounding inflationary pressures. In addition, the 2021 deficit included “only” $352 billion in interest expense associated with financing our national debt (now >$40 trillion).

The primary differences between 2021’s deficit and 2026’s are the facts that supply factors are not present as the economy is able to meet current demand with far fewer impediments and >50% of the deficit now pays for the interest expense on that $40 trillion national debt. Instead of going to individuals in the private sector that might use that $1 trillion in interest expense to demand goods and services, most of that interest expense is going to pension funds, insurance companies, banks, the Fed, foreigners, wealthy people. etc. According to my former INVESCO colleague, Charles DuBois, “only about 10-20% of the interest received is spent into the current domestic economy.”   

Consequently, today’s roughly $2 trillion deficit is much less stimulative than the $2 trillion deficits from 5-years ago. Chuck estimates that it is “perhaps about $0.6 trillion less stimulative”.  Inflation remains an issue, and may worsen should oil shocks materialize during the next several months, but it is not as bad as it could be if we were truly running a $2 trillion annual deficit with most of those $s flowing into the bank accounts of individuals, who like to spend!

12.20.24
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One of Only Two – Time For Change

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

The United States of America and Denmark share several commonalities. Both countries have democratic political systems. Each country enjoys a high standard of living. Both have a commitment to human rights and environmental concerns, with Denmark being a leader in renewable energy and sustainability, while the U.S. is witnessing a growing movement on those fronts. Both countries value education, enjoying high literacy rates. There is also a shared military alliance through NATO. What you might not realize is that the U.S. and Denmark are the ONLY countries that have a self-imposed statutory debt limit. Sure, there are other countries, such as Switzerland, that have mandatory balanced budget provisions which effectively limit the amount of debt , but they aren’t specified debt limits.

The U.S. first instituted a statutory debt limit with the Second Liberty Bond Act of 1917, setting the aggregate amount of debt that could be accumulated through individual categories like bonds and bills. The purpose in creating this legislation was to finance the country’s involvement in World War 1. The legislation allowed the U.S. to raise $9.5 billion in bonds that would be issued by the U.S. government. These bonds were marketed to the general population and to institutional investors to gain their support for the war. Was there a First Liberty Bond Act? Yes, that act had been passed earlier in 1917 allowing the government to issue $2 billion in bonds in order to support the war.

Importantly, and why we are where we are today with regard to the current deficit, the Second Liberty Bond Act program continued after the war. It set a precedent for public financing of government initiatives through bond sales. Although the debt limit was established in 1917 which allowed the Treasury to issue bonds without specific Congressional approval, the “limit” has been raised more than 100 times since then and roughly 78 times since 1960 alone. As a result, the US debt has risen from around $250 billion during World War II, to about $2.1 trillion during the Reagan years, to $5.6 trillion at the conclusion of the 1990s, and to today’s $36 trillion. So, why do we have a debt limit when it has been elevated so many times previously and to a magnitude certainly not contemplated in 1917?

The political brinkmanship associated with the debt limit debate rarely serves a purpose, often unnecessarily frightening Americans and our capital market participants. As we brace for another “discussion”, is maintaining a debt “limit” at all necessary? NO! Today’s federal deficit is in no way constraining to future generations. I’ve referenced Warren Mosler and his book, “The 7 Deadly Innocent Frauds of Economic Policy” on many occasions. He covers the topic of our government debt and whether we are leaving our debt-burden to our children, grandkids, etc. Mosler states, “the idea of our children being somehow necessarily deprived of real goods and services in the future because of what’s called the national debt is nothing less than ridiculous.”

As Mosler explains, that the financing of deficit spending is of “no consequence”. He further explains that when the “government spends, it just changes numbers up in our bank accounts.” The government doesn’t borrow money, it moves funds from checking accounts at the Fed to savings accounts (Treasury securities) at the Fed. The good news, is that the entire federal deficit ($36 trillion or so) is nothing more than the economy’s total holdings of savings accounts at the Federal Reserve. The private sector now has an asset equivalent to the deficit. How wonderful! Can you imagine if we didn’t have the ability to deficit spend. Think of all the stimulus that would have been removed from our economy that supported jobs, wages, and demand for goods and services.

The major issue with our ability to deficit spend has nothing to do with financing it, but everything to do with providing too much stimulus that creates demand for goods and services that exceeds our economy’s ability to meet such demand. So, I ask again, does having a debt limit (ceiling) make sense? No, unless you enjoy all the grandiose speeches from the halls of Congress based on little knowledge of how our monetary system truly works. Finally, I’d like to give a special nod to Charles DuBois, my former colleague at Invesco, who spent hours educating me on this subject. Thanks, Chuck!

10.11.24
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That’s comforting!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

The Fed’s meeting notes from the September 17-18 FOMC have recently been released. Here are a few tidbits:

Some officials warned against lowering rates “too late or too little” because this risked harming the labor market.

At the same time, other officials said cutting “too soon or too much” might stall or reverse progress on inflation.

Here’s my favorite:

Officials also don’t seem in agreement over how much downward pressure the current level of the Fed’s benchmark rate was putting on demand.

I have an idea, why don’t we just have each member of the Federal Reserve’s board of governors stick their finger in the air and see which way the economic winds are blowing. It may be just as effective as what we currently seem to be getting.

Given that the economy continues to hum along with annual GDP growth of roughly 3% and “full employment” at 4.1%, I’d suggest that having a Fed Funds Rate at 5.25%-5.50% wasn’t too constraining, if constraining at all. We’ve highlighted in this blog on many occasions the fact that US rates had been historically higher for extended periods in which both the economy and markets (equities) performed exceptionally well – see the 1990’s as one example.

Furthermore, as we’ve also highlighted, there is a conflict between current fiscal and monetary policy, as the fiscal 2024 federal deficit came in at $1.8 trillion or about $400 billion greater than the anticipated deficit at the beginning of the year. That $400 billion is significant extra stimulus that leads directly to greater demand for goods and services. How likely is it that the fiscal deficit for 2025 will be any smaller?

I believe that there are many more uncertainties that could lead to higher inflation. The geopolitical risks that reside on multiple fronts seem to have been buried at this time. Any one of those conflicts – Russia/Ukraine, Israel/rest of the Middle East, and China/Taiwan – could produce inflationary pressures, even if it just results in the US increasing the federal budget deficit to support our allies.

If just sticking one’s finger in the air doesn’t help us solve our current confusion, there is always this strategy:

06.25.24
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The Heavyweight Fight May Be Tilting Toward Fiscal Policy

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

You may recall that on March 22, 2024, I produced a post titled, “Are We Witnessing A Heavyweight Fight?”. The gist of the blog post was the conflict between the Fed’s desire to drive down rates through monetary policy and the Federal government’s ongoing deficit spending. At the time of publication, the OMB was forecasting a $1.6 trillion deficit for fiscal year 2024. As I noted in a post on Linkedin.com this morning, the budget office has revised its forecast that now has 2024’s fiscal deficit at $2.0 trillion.

This additional $400 billion in deficit spending will likely create additional demand for goods and services leading to a continuing struggle for the Fed and the FOMC, as they struggle to contain inflation. I also reported yesterday that rental expenses had risen 5.4% on an annual basis through May 31, 2024. Given the 32% weight of rents on the Consumer Price Index (CPI), I find it hard to believe that the Fed will be successful anytime soon in driving down inflation to their 2% target.

As a result, we believe that US interest rates are likely to remain at elevated levels to where they’ve been for the past couple of decades. These higher levels provide pension plan sponsors the opportunity to use bonds to de-risk their pension plans by securing the promised benefit payments through a defeasement strategy (cash flow matching). Furthermore, higher rates provide an opportunity for savers to finally realize some income from their fixed income investments. So, higher rates aren’t all bad! I would suggest (argue) that rates have yet to achieve a level that is constraining economic activity. Just look at the Atlanta Fed’s GDPNow model and its 3.0% annualized Real GDP forecast for Q2’24. Does that suggest a recessionary environment to you?

For those investors that have only lived through protracted periods of falling rates and/or an accommodative Federal Reserve, this time may be very different. Forecasts of Fed easing considerably throughout 2024 have proven to be quite premature. As I stated this morning, “investors” should seriously consider a different outcome for the remainder of 2024 then they went into this year expecting.