The two commonly followed gauges are the credit ratings assigned to UST via the credit rating agencies and Credit Default Swaps (CDS) traded in public markets.
Currently two of the three major credit rating agencies (Moody’s and Fitch) assign the highest credit rating of AAA to the debt of the United States. S&P rates them at a less than perfect AA+. Credit default swaps (CDS) are derivative contracts that enable an investor to buy insurance on the default risk of a debt issuer. If the issuer defaults, the insurance holder is made financially whole. The CDS of the United States currently trades at 27.5 basis points, which implies the odds of default are about 1.50-2.00%
A Third Way to Measure Default Risk
As Kevin Muir implies in his article, there is a third way to evaluate credit risk. Kevin wonders about the implications of a corporate bond trading at a lower yield than a U.S. Treasury of comparable maturity. I take that thought a step further. Could the spread between corporate bonds and UST, even though they are currently positive, be expressing heightened credit concerns for Treasury securities as opposed to less default risk for corporations?
What if the spread of AAA rated corporate bonds to UST were to tighten by ten basis points over the next month? Bond traders will robotically claim the spread tightening is a function of increased demand, reduced supply and/or a better economic outlook for the bond issuer. Given current circumstances, is it unreasonable to suggest that the yield on the corporate bond was unaffected and the yield on the U.S. Treasury increased due to credit concerns? Might it be possible the Sun has, against all conceivable logic, moved?
This concept is extremely hard to grasp, especially for those of us with decades of experience trading bonds. There are many instances in finance where a large majority of participants are gripped by muscle memory and habit. They are wed to the idea that the future credit history of the U.S. will be what it has been in the past. If we are to be successful investors over the long run, especially at crucial turning points, we must fight false assumptions, bad habits and challenge the durability of even the most basic “facts”.
Summary
Debunked facts are not only common but reflect a healthy progression of human knowledge. Such advancement, otherwise known as innovation and productivity, has led the human race to longer life spans, improved technologies, and greater economic well-being.
The fields of finance and economics, unlike most sciences, do not always seem to ascribe to the notion of incremental learning. Those in the financial community tend to repeat the same errors of the past. Just the past 100 years provides ample evidence of this through multiple boom-bust periods in which those Ph.D.’s from the best universities made the same critical mistakes. As such, the “growth” of logic and critical thinking in economics tends to be more cyclical than incremental. Mesofacts are presumed permanent, effectively stifling progress.
“I find it funny that the most vocal critics about the spiraling upward out-of-control government debt are often those investors’ most likely advocating positions in long-dated sovereign bonds as a place to hide. The surprise of this cycle will be that risk-free sovereign bonds provide no safety against the next crisis, but will instead themselves be the source of the instability. Think about hedging against the unthinkable happening.” – Kevin Muir
I concur with Kevin. No one has a crystal ball with the mystical ability to know when the imbalance of debt will overwhelm the nation’s ability to pay for it. I would argue that the United States is well beyond that point of no return and the missing piece of the puzzle is the point at which investors realize that fact. One glance at recent patterns of buyers of UST argues that some of our largest foreign sponsors may be asking these very same questions. That said, all investors should recognize that U.S. Treasury debt does indeed have credit risk and that risk is growing.
I intend to persuade you to think about things in ways that few do. In doing so, you will be able to rise above the large majority of investors that get caught in the sinkhole of cyclical thinking. Compounding your wealth will likely depend on it.
Twitter: @michaellebowitz
Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.
