Good evening, dear readers. The year’s horse races are over, and as fascinating as the purely political speculating, ranting, and raving is, the rest of the media has that well in hand. While it was indeed fun to weigh in on that subject, that is not the point of this blog, and we’re going to steer our articles back toward the politico-economic side of things. Today we’re going to look at the U.S. Treasury debt instrument (bills, notes, and bonds) and compare it to the debt instruments put out by corporations. Before you fall asleep from boredom, let me assure you that this will be a sobering look at what investors demand from the institutions from whom they purchase debt instruments and how they never get those demands met when buying from the U.S. government.
Debt works the same way in any case it is used, whether it be an individual obtaining a bank loan or a corporation issuing a bond. In each case money is exchanged in the form of a loan, to be paid back at a later date with interest. It is in the interest where the bank sees the profitability in offering the loan and where the investor sees the return in buying and holding the bond. So, an investor who buys a $1,000 bond at par (paying $1,000 exactly) with a rate of 5% will receive interest of $50 per year until the bond matures, at which point the $1,000 is repaid). Notes and bills work the same way, the only difference being time to maturity. These are the basics of debt, and to most this is nothing new.
But what is it that convinces an investor to buy a bond from one source as opposed to another? That reasoning lies in risk and return. The chance that a bond’s obligations will be met determines the debtor’s credit rating, which in turn determines the interest rate they are able to obtain. The better the chance the debt can be repaid, the lower the interest rate a creditor will accept. In other words, return is exchanged for certainty. The less of a chance there is that the debt can be repaid, the higher the interest rate the creditor will accept so that, on the off-chance the loan defaults, the creditor will have received as much money as possible from the transaction as possible in the form of interest.
These are the very basics of debt investments (more commonly known as fixed-income, but I’m referring to what they are in relation to the issuer, not the investor). Let’s dig a little deeper. How does an investor know that a debtor will make good? What the average investor will usually do is simply look at credit ratings from rating agencies like Fitch or Moody’s. Knowing the bang-up job such agencies have done of late, however, the more savvy investor might look further at the business itself and at the financial statements. Just as a bank wants a business plan with clear-cut cash flow projections from a small-business owner prior to granting a loan, it is a foolish investor indeed who does not make sure the company to whom they are loaning money will have enough cash on hand to pay the interest and principal when they come due.
What happens if enough cash is not on hand? If the money can’t be raised to pay debts (bonds, notes, bills), the company defaults on those loans. This is where collateral comes in. If one goes to a bank and asks for a loan it is expected that you can offer collateral, something of value that can be liquidated in the event that one defaults. Companies are the same way, with debt instruments being tied to accounts receivable, buildings, machinery, even whole business units, as things that can be sold to bring cash if regular revenue streams are insufficient. Of course, this is always a last resort, and any debtor needing to take that action has a very black mark on any subsequent ratings.
There is one type of bond, however, that is not attached to a concrete asset: the debenture bond. A debenture is backed only by the “full faith and credit” of the issuer. In other words, it’s good because they say it’s good. The risk here is assumed to be higher, and as a result the yields for debentures are always higher (remember, return goes up with risk). Defaults with debentures still look very bad for rating agencies, but there is very limited recourse open to the investor in such a case.
That’s all fascinating, you say, but how is this relevant to economics and this blog? Guess what backs U.S. Treasury debt instruments. Nothing. Zip. Nada. Zilch. Zero. U.S. Treasuries are backed by the “full faith and credit of the United States government.” Now, it is true that the United States has never defaulted on debt, but it is also true that the United States has not run a profit (a budgetary surplus) for more than three years in the last thirty (1998, 1999, and 2000). No business or individual can remain solvent only being profitable 10% of the time, yet there is not a business or individual in the world who can issue debt as cheaply as the United States government.
It is accepted as gospel in the securities market that the safest investments are U.S. Treasuries. If a client says, “I want the most conservative portfolio possible,” treasuries invariably play a starring role. Granted, you can’t get much. The yield (not coupon) for a bond maturing in ten years is only 3.48% (for every thousand dollars invested, the investor would see $34.80 in profit), which is just slightly above the rate offered by good savings accounts. Since savings accounts are guaranteed by the government under the FDIC, they are assumed to have no risk. Whether this is actually true is doubtful, but contractual obligations being what they are, in the event that the government and a bank failed at the same time I would think the FDIC obligations would have to be honored before bond interest (please correct me if I’m wrong).
I challenge anyone to bring up a company or individual that can run at a loss for 27 years out of thirty and still get loans backed by nothing but hopes and dreams. They don’t exist. That staggering level of ineptitude would have had shareholders melting tar and plucking feathers by year ten. Yet the U.S. government is still trusted to honor its debts. I grant you, it is unlikely that they will default on anything anytime soon, not because of some newfound fiscal responsibility but because of the printing press. Borrow and spend away: we’ll print the money to pay the interest. One small problem: inflation. That pattern of fiscal bacchanalia always leads to inflation, and when the national debt increases over 10% per year, inflation will come of the magnitude to make the 3.48% offered for the 10-year bond (a debenture bond in function) a sick joke.
I am of the opinion that those with fiduciary responsibility over clients’ assets (financial advisors and such) should not even look at treasuries outside of TIPS (inflation-protected securities) for the very simple reason that a thirty-year bond with a 4.39% yield in an atmosphere of 15% inflation (an Amishly conservative estimate) is effectively losing the client 10.61% per year (before taxes), with no exit for three decades. TIPS will help at first until everyone starts to want them, then the demand will send the premiums on the face value through the roof.
Economically, nothing is served by continuing to provide the fiscal babes-in-the-woods in D.C. with the means to obtain credit. It is easier in the short run, but like an addict just looking for another fix before promising to change within the next four years (“We just need the money for these last few projects.”), someone with the guts needs to stage an intervention and make them face the fact that the credit card that had two $700 billion “stimulus” packages tacked onto it in the last 15 months does not belong to those in Washington, and that it never did. It is absolutely unconscionable for those who keep trumpeting fiscal responsibility and vowing to root out waste in government to continue as they do. A politician without the understanding or the concern of economics would be better off not promising anything of the sort than offering the same empty promises about issues that get steadily worse because of, not in spite of, the dabbling of narcissistic dilettantes.
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