Is anything safe?
Photo: Josh Rogan. Source: Morguefile
For many, safety means credit risk, full stop. Johnson & Johnson bonds are less risky than Ford bonds—the company has less leverage, stronger cashflow, and more steady revenue growth. But safety is more than just having a AAA rating. A few years ago US was downgraded from AAA to AA by S&P and interest rates still fell rather than rising. Clearly, the market was looking at something other than credit risk.
Liquidity risk is real, too. In that regard, nothing can rival the US Treasury market. There are over $10 trillion US Treasury bonds, bills, and notes in circulation, and tens of billions outstanding in any single issue. The bonds are used to collateralize loans, other bonds, derivative contracts, and all kinds of other places where risk-free assets are needed.
By contrast, the most creditworthy nation in the world currently is Germany They have a modest operating surplus in their government account and a diversified economy that is globally competitive. To many, Germany is the epitome of sound fiscal management.
But there’s a problem in paradise. If people want to use German bonds as collateral, it’s hard to find them. And if they do find them, and need to sell them, there aren’t a lot of buyers. The market for German sovereign debt is thin. Finally, safe, short-term German debt carries a negative yield. 5-year German Bunds yield 0-0.25%. You have to pay more for the bonds than you eventually earn in interest. Who wants to invest in something guaranteed to lose money?
German Government Bonds. Source: Bloomberg
Safety isn’t just the assurance of getting your money back. It’s getting your money back when you want it. Smaller bond markets simply can’t do this. For that you need liquidity. And that makes US Treasuries the safest asset in the world. Having a deep, liquid, and creditworthy bond market carries tremendous advantages. Let’s hope we can keep it that way.
Douglas R. Tengdin, CFA