The risks of risk-free bonds

By Howard L. Simons
One of the fairy tales taught to finance students is something called “the risk-free rate.” Although commonly understood to represent a cash-like instrument, such as the three-month Treasury bill in the U.S. and other short-term government debt elsewhere, the simple fact of the matter is, no instrument is risk-free. Everyone’s paper currency is subject to the risks of inflation and to the currency becoming increasingly worthless on world markets — and that’s before accounting for extraordinary events such as whether the Euro disappears. Many of you probably know someone who trades in the scripophily market, and who will gladly sell you a handful of Confederate or Czarist bonds. Lincoln importuned against the government of the people, by the people, and for the people perishing from the earth, but such things do happen.

Beyond physical disappearance, the biggest risks to risk-free government debt are excessive monetary creation and excessive levels of public debt. If this sounds like the course of action taken globally during the financial crisis beginning in 2007, it is. Fortunately (or unfortunately, as the case may be), the much-maligned credit default swap (CDS) market for insuring government debt became active during 2007 and started to provide a window into what investors thought of each government’s credit risk. A higher CDS cost represents a lower credit quality for the country in question.

The standard CDS contract is for $10 million of underlying debt and is quoted in basis points. All the costs quoted here are priced in U.S. dollars except for the CDS on U.S. Treasury debt, which is quoted in Euros on the amusing assumption that if the U.S. defaults, the Euro bloc will be unaffected. Assumptions are wonderful things.

The CDS market became a good barometer for general risk levels, both higher and lower, after 2007. It should surprise no one that CDS levels surged higher not only into the September 2008 default of Lehman Brothers, but all the way into the Obama administration’s February 2009 budget announcement. For the U.S., the peak occurred February 23, 2009; this was followed by a joint statement from the Federal Reserve and the Treasury Department they would not allow further financial system failures. Translation: They would print the money and give it to you, thereby eliminating the risk. Hmmm. Two weeks later a round of quantitative easings began with the UK and Switzerland announcing they would start the printing presses. The U.S. followed suit, and global financial markets took off in celebration.

For the complete article, see the October 2010 issue of Active Trader magazine. Click here to subscribe.



|

|