U.S. Treasuries: Not a 'Risk-Free Asset' 27 comments
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The US Treasury bond has earned the reputation of the safest asset by being the most liquid, and issued by the most politically stable country, with the largest economy and strongest military. When the wonks perform long term studies of asset class returns, they typically call the US Treasury the "Risk-Free Asset." While this may be an academic term, this "Risk-Free Asset" is not risk free.
There is no such thing as a "Risk-Free Asset". All bonds, whether sovereign or corporate have many risks: risk of default (issuer risk), liquidity risk, currency devaluation, inflation, call risk, term risk and rising interest rates. Sovereign Debt is issued by governments, therefore US Treasuries are considered Sovereign Debt.
- Default Risk: Within the same country, Sovereign Debt is generally less risky than corporate debt, especially in a period of high stress.
- Liquidity Risk: US Treasuries are the most liquid - and high liquidity means safer. US bonds are the most liquid because they are the bonds most often issued, because the US is the world's largest debtor. It is ironic that the largest debtor becomes the safest debtor because of the liquidity of its bonds.
- Currency Devaluation: A US-based investor who spends only in dollars and holds dollar-denominated bonds; technically has no currency devaluation risk. On the other hand, if this same investor held bonds in foreign currencies (WIP) that depreciate against the dollar, the investor would receive fewer dollars when cashing in.
- Inflation: By far, inflation is the largest threat to bonds. Inflation-protected bonds protect you against inflation and to a lesser extent against devaluation (because devaluation stimulates inflation). Because of this, inflation-protected bonds are less risky than nominal bonds (same issuer). There are very few corporate inflation-protected bonds as most are issued by governments. The inflation-protection is only as good as the accuracy (honesty) of the CPI reported by the government. Many pundits (myself included) believe that the US is grossly under reporting their CPI. As for Foreign CPIs, Pimco's Bill Gross believes they are for the most part, accurately calculated.
- Call Risk: When a company issues a callable bond at 10% and the prevailing interest rater later declines to 8%, the company may decide to call in its bonds. By buying back its bonds, the company can save money by issuing new bonds at a lower interest rate. US corporate bonds are generally subject to call risk. US Treasuries cannot be called.
- Term Risk: The longer the bond maturity, the riskier it is. This is because the longer a bond’s maturity, the more likely the bond will be decimated by inflation and/or devaluation. As well, long bonds are more susceptible to being called.
- Rising Interest Rates: As rates rise, long bonds drop in value. Inflation and Rising Interest Rates are bond destroyers.
Rising Interest Rates
As the following chart shows, interest rates on 30 year bonds are the lowest they have been in the last 30+ years. The chart is hard to read, but it begins in 1977 and ends in 2008. Rates have ticked up somewhat since 2008. As rates rise, long bonds drop in value. Conversely, as rates fall, long bonds rise in value.
Bull Market in Bonds
The sustained fall in long term interest rates since 1982 has been the main driver behind the 27 year bull market for bonds. Any study that begins in 1982 comparing long bonds with the S&P500, will show that performance of 30 year and 20 year bonds has nearly equaled that of the stock market.
It is unwise to assume that bond yields will stay at or near their current multi-decade lows. Bond yields are sure to rise and bond prices are sure to fall, thus hurting bond portfolios.
Default
Sovereign nations do default, and sometimes unexpectedly. For example, Due to its oil wealth, Ecuador had plenty of money in the bank. Even though it was not forced to default, it chose to do so. When people talk of the risk of default of sovereign nation, they are usually referring to foreign (non-US) countries. Nowadays, no one knows who is next in line to default. Since the U.S. is a Sovereign nation, it is subject to default. The likelihood of this is very low, as I wrote in an earlier article.
How to Lower Risk
Stacking the risks above, the least risky bonds are Sovereign (less default and liquidity risk, no call risk) Inflation-Protected, shorter-term bonds. This boils down to: Inflation-Protected Sovereign (government-backed) bonds. You can buy a diversified pool of these two bonds in convenient ETF form with the symbols TIP (US Government) and WIP (Foreign Governments). Click here to read more about WIP. Click here to read more about TIPS.
Diversification Lowers Risks
A diversified portfolio of sovereign bonds is far less risky than holding the bonds of a single foreign country (a single issuer). (This point is tempered by the fact that you are exposed to currency risk). A diversified portfolio of assets, some of which are risky (even including a sprinkling of risky Italian Sovereign bonds) become a lot risky when blended in a diversified portfolio – this is the magic of diversification. It can be empirically proven that a portfolio of 100% US Treasury bonds is riskier than a portfolio of 80% US Treasury bonds and 20% Foreign bonds.
US Treasuries Are Not Risk-Free
US Treasuries have the same implicit risks of all bonds. They are certainly not risk-free. In two previous articles, I have argued that US Treasuries are riskier than other bonds. Take nothing for granted, don't assume that even the mighty US Treasury bond is safe. Spread your bets
Disclosure: Author is long individual US TIPS and WIP. You should consult with a professional before investing.
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This article has 27 comments:
Does this not make the US Government guilty of fraud?
With all the excess home inventories, record high vacancy rates, and landlord wannabes, we can expect this portion of the CPI to stay low for many years to come.
Though it seems to me that the horse in question has so manifestly left the barn, as to call into question who is left to warn?
In any case, we know the CPI statistics are wrong, and make an estimate to how far they are wrong and then act accordingly.
On Jun 21 03:40 AM Dave Wrixon wrote:
> "The inflation-protection is only as good as the accuracy (honesty)
> of the CPI reported by the government. Many pundits (myself included)
> believe that the US is grossly under reporting their CPI. "
>
> Does this not make the US Government guilty of fraud?
When analyzing any investment I like to break it down to it's basics. What are the basic underlying assumptions? What are the underlying risks?
To answer your question: The article was more of a diatribe against all nominal bonds, not necessarily treasuries. TIPs have there problems too.
There are plenty of bond bulls out there. Bonds aren't the safe investment people once thought. Consider all the risks, and all the merits and then devise your allocation accordingly.
On Jun 21 04:15 AM Jasper M wrote:
> This article is a pretty good pirmer on the subject.
> Though it seems to me that the horse in question has so manifestly
> left the barn, as to call into question who is left to warn?
There is not much upside when Base Rates are at Zero.
About Interest rate risk read:
The Risk in Long-Term Interest Rates and Stagflation.
seekingalpha.com/artic...
That said in a Liquidity Trap only Cash and Short Term Assets (Gold and Silver) are King!
On Jun 21 08:36 AM Dave Wrixon wrote:
> Plenty of people lost their arse on bonds in the 1970's as inflation
> roared, but as inflation came down they were a sure fire winner.
>
>
> There is not much upside when Base Rates are at Zero.
Thanks for the link
On Jun 21 08:40 AM Shalom Hamou wrote:
> Treasury Bond have only interest rate risk which is a systemic undiversifiable
> risk meaning that it is impossible to diversify away from it.
>
When he says that CPI is accurate, it must be taken with several grains of salt.
On Jun 21 09:30 AM Living4Dividends wrote:
> Dave - You made two excellent points! I especially like your second
> point.
>
> On Jun 21 08:36 AM Dave Wrixon wrote:
It is not China that will pull the rug under Treasuries. It is the Fed when it sticks interest rates up. I am guessing that Washington and Beijing have agreed a mutually acceptable exit strategy for both parties which will sucker just about everyone else in the market. If these two Giants are going to come out with a few cuts and bruises then everyone else gets burnt.
On Jun 21 08:40 AM Shalom Hamou wrote:
> Treasury Bond have only interest rate risk which is a systemic undiversifiable
> risk meaning that it is impossible to diversify away from it.
>
> About Interest rate risk read:
>
> The Risk in Long-Term Interest Rates and Stagflation.
> seekingalpha.com/artic...
>
>
> That said in a Liquidity Trap only Cash and Short Term Assets (Gold
> and Silver) are King!
And of course, the old Bill Gross (pre 2009) was certainly biased in that he made a living selling bonds.
Given that he is a bond guy and an establishment type, you'd be surprised to read Bill Gross'es June 2008 article slamming the accuracy of the US CPI. I posted it in my instablog, just in case Bill Gross decides to erase the article from his website, at the urging of his new benefactors.
seekingalpha.com/insta...
On Jun 21 09:41 AM yellowhoard wrote:
> As much as I admire Bill Gross, he is part of the establishment.
>
>
> When he says that CPI is accurate, it must be taken with several
> grains of salt.
I would love to hear your comments.
On Jun 21 09:54 AM ksmithdc wrote:
> Interesting read, thanks.
> It the ubiquitous denial of the associated risks that make Treasury
> Bonds so dangerous.
Wow! That's an excellent way of putting it. So true, so true. The statement is so universal, it could be applied to other issues.
I would like to hear your differing conclusions.
On Jun 21 10:15 AM Ferdinand E. Banks wrote:
> It's been a long time since I thought about the risk of US Treasury
> Bonds, and I arrived at some different conclusions from the author.
> But he might be right. I hope that at some point in the near future
> I will get the opportunity to tell my students to read this well
> written and pedagogically valuable article.
Nothing prevents the Treasury from "buying in" Treasury bonds and shifting its interest cost to lower current borrowed funds.However,done on a large scale,the bondholder is sure to get an additional premium from the market,albeit,the rest of us paying somehow.
Enjoyed the analysis.
For all intents and purposes, Treasuries are non-callable.
On Jun 21 12:09 PM Badgolfer wrote:
> 5. It's stated that U.S.Treasuries cannot be called.I seem to remember
> that some 30 year Treasuries can be called under certain circumstances
> but never have been because of the expected reaction.
> Nothing prevents the Treasury from "buying in" Treasury bonds and
> shifting its interest cost to lower current borrowed funds.However,done
> on a large scale,the bondholder is sure to get an additional premium
> from the market,albeit,the rest of us paying somehow.
> Enjoyed the analysis.
If indeed there is price manipulation taking place, then when the price drops it would trigger a margin call, thereby causing the sale of the Chinese owned Treasuries and weakening the U.S. dollar, with corresponding upward pressure on interest rates. Smart move! How can they be blamed for 'dumping' Treasuries when they 'lose' on the stock market? They are in a win, win situation, and the manipulators would be caught between a rock and hard place!
> There are reports that the Chinese are about to put some major financial
> weight into hedge funds. They are going to be pledging significant
> amounts of U.S. Treasuries from their reserves as collateral in margin
> accounts, specifically gold.
Sounds accurate and sounds like a reasonable for the Chinese to do.
> If indeed there is price manipulation taking place, then when the
> price drops it would trigger a margin call, thereby causing the sale
> of the Chinese owned Treasuries and weakening the U.S. dollar, with
> corresponding upward pressure on interest rates. Smart move! How
> can they be blamed for 'dumping' Treasuries when they 'lose' on the
> stock market? They are in a win, win situation, and the manipulators
> would be caught between a rock and hard place!
Hmm.. the above is too Machiavellian for me.
Factor that determine probability of sovereign debt default/rescheduling
Debt service ratio
Import ratio
Investment ratio
Variance of export revenue
Domestic money supply growth
On Jun 22 08:01 AM tuj wrote:
> The question really is, how does one assess the default risk of a
> Sovereign Nation? Certainly an Ecuador is not the same as the US
> or even the UK for that matter. While diversification makes sense,
> should one not seek to compose a 'risk-weighted' portfolio? And is
> it possible that the risk weight for the US debt is so low compared
> to the alternatives as to comprise nearly all of this portfolio?
> I cannot say; open to suggestions.
The US (afaik) has never defaulted on its debt. Obviously the money supply has grown substantially, and the trade balance has been negative for quite a while.
The US is the consumption 'sink' for the export economies of the world (China, Japan, Germany, etc) with the Eurozone being a secondary 'sink'. Japan tends to satisfy its consumption domestically as does Germany, so that leaves a real question: who is going to be the buyer going forward? A rising Asian middle class will take time to fulfill this role.
I keep coming back to the military point; the US spends a massive proportion of GDP on this, more than the next 13 nations combined. What sort of 'premium' does US debt command for assuming the role of world security provider?
> What about military strength? Certainly if push came to shove, the
> US implicitly protects the security of many of its largest debt holders
> (thinking here of the Caribbean banks and Japan). And the off-shore
> banking countries generally have a dollar peg (along with doing virtually
> all their business with the US), so I don't see them as having any
> reason to sever the relationship. The Japanese avoid the peg issue
> but still have an export-driven economy and there really aren't a
> whole lot of places to dump Toyola's right now; China isn't a big
> enough market yet.
>
> The US (afaik) has never defaulted on its debt. Obviously the money
> supply has grown substantially, and the trade balance has been negative
> for quite a while.
>
> The US is the consumption 'sink' for the export economies of the
> world (China, Japan, Germany, etc) with the Eurozone being a secondary
> 'sink'. Japan tends to satisfy its consumption domestically as does
> Germany, so that leaves a real question: who is going to be the buyer
> going forward? A rising Asian middle class will take time to fulfill
> this role.
>
> I keep coming back to the military point; the US spends a massive
> proportion of GDP on this, more than the next 13 nations combined.
> What sort of 'premium' does US debt command for assuming the role
> of world security provider?