Tuesday, March 10, 2009

Treasuries No Longer Considered Risk Free

Marketwatch reports that the cost of credit default swaps for U.S. Treasuries is rising. The significance of this is that Treasuries are no longer considered to be 100% risk free. Usually, in finance classes, they use the yield of government securities as the risk free reference rate in for example the CAPM formula. But this presupposes that everyone perceives these securities as being risk free, something which is evidently no longer the case.

Personally, I don't think there is any risk of default for a government that issues debts in its own currency and has a fiat currency with a floating exchange rate, as it can always print whatever money it needs to pay. That might lead to a de facto default, as the real value that investors get back is lower, but it won't be the kind of formal default that credit default swaps protects you from. So the people buying these swaps are wasting their money for nothing. But that's their problem, and the point remains that Treasury yields thus contain a risk premium, and cannot be used as the risk free reference rate.


Blogger Reginald said...

It certainly is odd. Considering there are no gold clauses in debt contracts to counteract currency debasement, I'd love to sell those credit default swaps. I guess all sorts of new distortions are occurring due to government intervention. Until the disinflation reverses I don't know what to expect.

11:43 PM  
Blogger HellKaiserRyo said...

I do not know what is safe anymore Stefan...

Do you think German Bunds and JGBs are safe? I like German bonds and Swedish sovereign debt although presumably the market for the latter is less liquid.

What do you mean by risk premium if it is paid by printed money? Don't you mean "inflation premium" although it seems to be a non-trivial risk in the future that the velocity of money will speed-up dramatically if the governments of the world gets too complacent about printing money. Of course, in these times, cash is valued and the velocity of money is rather slow.

What do you think is the "risk premium" on gilts are?

12:14 AM  
Blogger fds said...

"...I don't think there is any risk of default for a government that issues debts in its own currency...So the people buying these swaps are wasting their money for nothing."

I think your logic is flawed. The MarketWatch article states that the US swaps are at France levels. As far as I know, France is on a fiat currency, along with the rest of the planet. If fiat countries have no risk of default thanks to printing presses, then there shouldn't be a market for sovereign credit swaps. I seriously doubt there exists a market mispricing that involves an entire market!

5:30 AM  
Blogger stefankarlsson said...

Reginald: Yes, of course, sellers of these CDS's get a very great deal.

HellKaiserRyo: Japanese and Swedish government bonds qualify as safe from formal default in the same sense as U.S. Treasuries, as both Japan and Sweden have independent fiat currencies with floating exchange rates.

German government bond are not fully as safe as Germany no longer have its own currency. But German Bunds are as I understand generally perceived as safe, and perceptions is what matter in this context.

As for "risk premium", in this context it is unrelated to inflation premium since credit default swaps won't protect you from inflation.

FDS: First of all, what's so impossible about financial market failure? Didn't NASDAQ trade at 5,000 9 years ago?

And BTW, France does not have its own currency. It's part of the euro area and so the French government can't print money at will.

11:17 AM  
Blogger Arturs said...

Isn’t it true that USA may default technically if it starts borrowing in foreign currency (e.g. triggered by lower rates, which in turn triggered by drop in USD value, which in turn triggered by China disposing of it’s reserves)?

1:27 PM  
Blogger happyjuggler0 said...

I can think of two scenarios in which the US might hypothetically default on US dollar denominated Treasuries.

First, the US Treasury could find itself in a position where it needs to refinance, but can't. Then if the Fed refuses to "print" money, the result if default. Of course, the White House and Congress could replace the Fed members by legislation, but it might be too late for the first round of defaults.

Second, the US government could be comprised of politicians who would see defaulting as something desirable (!) since it "solves" the debt problem, in their warped view of course.

I have no trouble conceiving of the second scenario happening at some point after the baby boomers start retiring and the government suddenly finds itself in a massively underfunded position, especially after Obama's current spending binge.

4:42 AM  

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