The myth of riskless debt

Apr 22, 2012·James Turk

Much has been learned from the ongoing financial debacle that has been painfully rattling the world’s financial structure in recent years. Foremost among these valuable lessons is the realisation that all financial assets have risks.

Even the bonds of many sovereign nations are being called into question, and rightly so. Though often deemed to be “riskless” because of a country’s ability to extract tax from its citizens, logic tells us that nothing in life is risk-free. This conclusion can also be reached by even a cursory reading of monetary history, or in a more meaningful and instructive way, just by closely observing financial events in recent years. Unquestionably, sovereign bonds have risks.

In fact, there are three of them. Each of these risks needs to be seriously considered and analysed before purchasing the bond of any sovereign nation.

1) Currency risk – There are two types of currency risk. The first is inflation, which has been eroding the purchasing power of currencies ever since governments abandoned the classical gold standard decades ago. This risk is particularly acute in today’s environment in which continuous central bank intervention manipulates artificially low interest rates, with the consequence that the interest income earned on a bond is not likely to completely offset the loss of purchasing power of the currency in which the bond is denominated. The other currency risk comes from fluctuating exchange rates. A declining exchange rate will reduce the value of bonds denominated in a foreign currency. For example, any euro-based investor who owned bonds denominated in British pounds saw their wealth eroded when the pound’s exchange rate collapsed against the euro a few years ago.

2) Interest rate risk – Although central banks have been actively intervening in the credit markets to keep interest rates low, it is inevitable that interest rates will again rise. Rising interest rates mean that bond prices will fall. Bond prices will fall so that the yields of the bonds’ coupons will always equal the prevailing interest rate.

3) Counterparty risk – Most devastating of all is the risk of default. A country will repay its bonds only if it has both the financial capacity and the willingness to repay. In this regard, investors are learning from recent events that many countries have exceeded the ability to repay its debts, even if they want to do so.

Despite these recent events, many bondholders still believe that they can achieve a favourable risk/return ratio by owning a government bond. While that assertion may have been true in the past, most governments today are over-leveraged and stretched to the limit. It is no longer reasonable to expect that a government bond can be bought and held to maturity. They have become a trading vehicle, to be bought and sold like commodities in an attempt to profit from price fluctuations. This task requires unique skills, so it is best to leave the ownership of sovereign bonds to professional traders and speculators.

As a consequence of countries living far beyond their financial capacity, many promises made by politicians are going to be broken. This will include the insincere promise to always honour a country’s debts. The plain truth is that many governments around the world are running out of money, and in that environment, sovereign bonds are not risk-free.

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