Risk-Free is Not Without Risk

“All things must pass,” George Harrison mournfully crooned on his 1971 album of the same name. “All things must pass away… Sunrise doesn’t last all morning… A cloudburst doesn’t last all day”…and neither does a superpower’s global economic hegemony.

America’s dominance of the global economy is falling victim to self- inflicted wounds – namely, extreme and rising indebtedness. America’s recent flood of red ink would make a banana republic blush.

As a result, risk-free Treasury bond may not be as “risk free” as they used to be. A few days ago, the highly regarded hedge fund manager, Julian Robertson, revealed that he is purchasing long-term put options on long-term Treasury bonds. His reasoning is persuasive.

“If the Chinese and the Japanese stop buying our bonds,” Robertson explained during a CNBC interview, we could easily see [rates] of 15% to 20%…It’s a question of who will lend us the money if they don’t. Imagine us getting ourselves into a situation where we’re totally dependant on those two countries. It’s crazy.”

Crazy, yes, but true.

The US financial markets, especially the credit markets, benefit greatly from both familiarity and reputation, more than merit; past reputation, more than future reliability. But “reputation” doesn’t pay the bills.

The growth of emerging economies is “symbolic of the relative, less dominant position the United States has, not just in the economy but in leadership, intellectual and otherwise,” Former Federal Reserve Chairman Paul Volcker said in an interview with Charlie Rose recently.

“I don’t know how we accommodate ourselves to it,” Volcker continued. “You cannot be dependent upon these countries for three to four trillion dollars of your debt and think that they’re going to be passive observers of whatever you do.”

The US government, like one giant General Motors, is technically insolvent. And yet, it borrows at AAA rates because of its long-term legacy of world-beating economic success. NOT because of its recent history of extreme indebtedness.

The fiscal condition of the United Sates has deteriorated dramatically during the last several years. On the basis of current obligations, US indebtedness totals “only” about $12 trillion. But when utilizing traditional GAAP accounting – the kind of accounting that every public company in the United States MUST use – US indebtedness soars to $74 trillion. This astounding sum is more than six times US GDP. (GAAP accounting includes things like the present value of the Social Security liability and the Medicare liability – i.e. real liabilities.)


Perhaps this mind-blowingly large debt load would seem less mind- blowing if it were DE-creasing. But it is not. Instead, the current US administration is amplifying the long-standing American habit of spending money it does not have.

The chart below tracks the federal budgets for both America and Brazil as a percentage of each country’s GDP. Back in 1998, the US ran a budget surplus, while Brazil was running a deficit equal to 9% of GDP. But the two nations have traded places. At last count, the US budget deficit totaled an astounding 9% of GDP, while Brazil’s deficit totaled only 3.3%.

US vs. Brazil Budget Deficit

And yet, The US government pays only 3.28% in interest per year to borrow money for 10 years; while the Brazilian government must pay 5.05% to attract investors to its 10-year bonds. Thus, the yield spread between these two borrowers is 1.77 percentage points – or 177 “basis points.”

A brief tutorial may be in order at this point…

Like a polite dinner guest, the bond market does not express its opinions in absolute terms. Rather, it renders a relative judgment. Its prices specific bonds relative to other bonds, or specific credit instruments relative to others. This relative pricing is known as the “yield spread.” (A very common yield spread comparison is made relative to Treasury bonds). So for example, if a certain 10-year bond issued by a corporation or a foreign nation’s yielding 6.50% at the same time that the US 10-year note is yielding 4.50%, that bond is said to be trading 200 basis points (i.e. 2.00%) over Treasurys. The higher the spread over Treasurys, the riskier the debt is perceived to be.

But this is where our story takes an interesting turn. The yields on foreign sovereign bonds (i.e., government bonds) have been falling closer to US yields for several years. This process has been unfolding gradually, and in fits and starts. But over time, the trend is clear. What’s not clear is who is moving closer to whom. Are foreign sovereign issuers becoming MORE credit-worthy or is the US government becoming LESS credit-worthy? Or is it a little bit of both?

Whatever the case, the nearby chart illustrates the result. Using a four-year rolling average of yields (to smooth out the trend), it is easy to see that Developed World interests rates are converging toward US rates. Canadian and French sovereign 10-year interest rates, for example, have been moving closer to US rates for several years. (And in fact, French rates have dipped below US rates several times during the last several years).

Death of AAA Credit

This narrowing of yield spreads is not only evident among issuers like Canada and France, but also among emerging market issuers, especially the rapidly emerging market issuers like Brazil. Some investors might infer, therefore, that emerging market bonds are too expensive, relative to Treasurys. We would take the other side of that trade.

Risk-free Treasury bonds are not as risk-free as they used to be.


Eric J. Fry
for The Daily Reckoning