May 22, 2010

How Safe Are US Treasuries?

This week saw another mini-flight to safety.  The Euro was pushed down to the lowest point in about 4 years (before recovering), US Treasuries and other Bonds saw yet again an influx of scared money fleeing the global financial markets in drones.  But within this trend towards the illusive safety, many investors forget that US Treasuries and similar AAA rated sovereign debt instruments are not without risk.  I am not referring to pure credit risk but also to the inherent risk from the mechanics of Bond prices.  Although this is very basic, here’s a graphic reminder of the relationship of Bond prices to changes in interest rates.


The prices of Bonds, particularly the longer term Bonds (10, 20, 30 years), are rather sensitive to changes in interest rates.  Unless you hold a Bond to maturity, its price can fluctuate rendering your investment not all that risk-free after all.  Pension funds, Bond funds and Bond ETFs are not immune to this - something to consider before pouring all your money into the “safest of all” asset classes.

US short term rates are still at zero which makes it less likely that Bond prices could rise much further.  But let’s assume that the US will experience a multi-decade period of near zero short-term interest rates just like Japan since 1990.  What is the likelihood that longer-term Treasuries will retain their current ratings allowing them to continue to finance deficits at ultra-low rates?

IMHO, the Greek and Euro-zone crisis should serve as a wake-up call.  The long-held believe in the risk-free rate is beginning to fade.  Several US States, California being one of them, have budget deficits approaching Greek standards. Unfunded liabilities continue to rise, entitlement cuts are political suicide and therefore they cut the lowest hanging fruit first, education being one of them. 

For California, the proposed budget cuts in education have been so drastic that Bond ratings agencies are now concerned about the long-term impact of these measures.  California and other US States are slowly approaching a tipping point of being no longer economically viable.  In order to assess the credit worthiness of say a 30-year municipal Bond, ratings agencies must now consider whether California will have an educated enough labor pool to continue generating enough middle-class earners for the much needed tax revenues. By cutting education to the bone, governments dumb down society as a whole rendering their own state or country unable to get out of the debt spiral. For now, the ratings agencies are merely concerned that their clients might actually be paid back in 30 years.  But with further cuts in education and other areas which contribute to the long-term economic viability of society, we should not only be concerned as long-term Bond investors.  Instead of cutting education, research & development programs for new and alternative energy, California as well as other States should heed the wake-up call from Greece. They must come up with cost-cutting measures for programs that do NOT contribute to sustainable long-term growth i.e. ridiculous pension and entitlement programs or building bridges to nowhere.  If they don’t, the consequences are also clear.  Long-term financing at ultra-low rates will become increasingly difficult not just for California, Michigan and New York but it will affect US Treasuries, the mother of “all risk-free” investments.

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