Government Bonds: No Longer a World Without Risk

By José Viñals

The risk free nature of government bonds, one of the cornerstones of the global financial system, has come into question as the global crisis unfolds.

One thing is now very clear: government bonds are no longer the risk-free assets they once were. This carries far reaching implications for policymakers, central bankers, debt managers, and how the demand and supply sides of government bond markets function.

After a recent IMF conference on a new approach to government risk, I’d like to highlight three key aspects:

  • In a world without a risk free ratethe health of the financial sector and the government are closely interconnected. We need to better understand the linkages between sovereign and financial risks, and conduct a thorough analysis of the channels of cross-border spillovers. Policies to help manage sovereign risk will have a positive impact on financial stability, and measures to stabilize the banking sector will have a favorable impact on sovereign balance sheets.
  • Countries with large potential liabilities from their banking sectors need to identify, assess, monitor, and report related risks closely. The impact of these contingent liabilities on the government’s financial position, including its overall liquidity, needs to be assessed when making borrowing decisions.
  • The risks involved call for stronger emphasis on stress tests. There is anecdotal evidence that some debt managers are complementing existing analytical approaches with a greater focus on stress scenarios, including extreme financing shocks. Policymakers could take the extra step and contemplate the role for a joint stress test for systemically important financial institutions and sovereigns. The outcomes of such stress tests could help inform crisis preparedness, debt strategies, as well as financial supervision and regulation.

Implications for supply and demand

These views are the result of some recent profound changes in the way government bond markets operate.

On the demand side of the market, dealers and investors no longer treat these bonds as purely interest rate products. Far from it, government bonds have assumed characteristics typical of credit products, for which prices mainly provide measures of borrowers’ probabilities of default. Many are not as liquid as before and their investor base is not as diversified as it used to be. During phases of risk aversion, they do not benefit from flight to quality flows. On the contrary, they correlate with risky assets.

Credit rating downgrades play a procyclical role and can exacerbate these adverse dynamics. Central bankers generally accept government bonds as collateral in refinancing operations, but, below certain thresholds, lower ratings could trigger sizeable haircuts, in other words, revaluing the bonds substantially below their market value.

Regulators could also assign them a non-zero risk weight under the standardized approach and suddenly these bonds are not risk-free rates any longer. And even if bonds such as United States Treasuries and German Bunds have retained most of their risk-free characteristics, the once solid dividing line between interest rate and credit products has become blurred.

In the long run, such changes can profoundly affect investors’ choices. One example of these changes is that more capital may flow towards emerging markets. These economies have been able to absorb the recent inflows, but the increase in corporate and financial leverage, rising asset prices, and building inflationary pressures may soon translate into growing imbalances and open the door to a new set of challenges to financial stability.

On the supply side of the market, debt managers in advanced economies have started behaving a bit like their emerging market colleagues. Given the increased exposure to economic and financial risks, they have started placing stronger emphasis on risk mitigation strategies, well beyond what traditional debt management objectives would indicate.

Confronted with the usual trade-off between being predictable or flexible, most of them have erred on the side of flexibility. While retaining an open dialogue with financial markets, they realize that annual programs have to offer sufficient flexibility to cope with the challenges of issuing and managing larger amounts of debt. Finally, debt managers are putting a high premium on proactive and timely communication as well as on understanding the evolving nature of the investor base. These are precisely the elements that were outlined in the ‘Stockholm Principles’ IMF facilitated with the debt managers in September 2010.

The global crisis is sending many of us back to the drawing board to take a fresh look at old assumptions and long cherished principles, and the risk free nature of government bonds is no exception.

33 Responses

  1. Does anyone think that the Euro currency will be only the currency of Germany and France within 5 years? As Greece, Italy, Ireland, and Spain will revert back to their own currencies soon? I read an article about the whole Euro zone crisis at http://www.instantfxalerts.com well worth a look at.

    • Guys, if inflation is your biggest worry, you have a wonderful life, indeed. And, if inflation has you concerned, buy TIPS. Then, you’re fully protected.

      Or buy gold and go down the tubes when the bubble bursts.

      • With a government bond in the hand you may either get nothing or go to court to get your money back. With gold you don’t have to go to court, you just go to the market and someone will always be a willing buyer. Curiously though, how is it that gold is in a bubble when the amount of new gold that has come into the market over the last 10 years is absolutely dwarfed by the amount of new debt that has come onto the market? Isn’t it the case that government debt is the one that is the true bubble?

  2. [...]   Mouse here for Related LinksGovernment Bonds: No Longer a World Without Risk [...]

  3. Absolutely agree. No risk, no gain

  4. The IMF does not, and never has, understood Monetary Sovereignty (http://rodgermmitchell.wordpress.com/2010/08/13/monetarily-sovereign-the-key-to-understanding-economics/ )

    Nor does the EU. That’s why the euro was conceived in the first place.

    Rodger Malcolm Mitchell

  5. In these days nothing is risk-free and more that I invested in Forex.

  6. There is a huge difference in the default risk of sovereign debt denominated in the currency of the sovereign borrower and sovereign debt denominated in a currency which the borrower cannot issue. This is the problem with the Euro – Portugal cannot issue Euros. Thus, it is entirely possible that Portugal will be unable to pay its debt in Euros. On the other hand, Japan, the UK and the USA all have central banks which can issue yen, pounds or dollars and buy government debt – for these sovereigns a default in their own currencies is extraordinarily unlikely. Another situation to distinguish is a sovereign which has debt in a completely foreign currency – Venezuelan debt denominated in dollars – here, again, there is a real risk that they may not be able to come up with the dollars. I think that this is an important distinction and I am frankly surprised to see a piece from the IMF that does not point this out.

  7. Kenny, define “collapse.”

  8. So, what other types of investments would get to as close to risk free as government bonds used to be?

  9. totally agree,nothing is risk free!!

  10. [...] not trivial. For this reason one of the themes of the March IMF conference is how we understand a world without a risk free rate. I’ve been reflecting on this theme in terms of our economic models of market incompleteness. [...]

  11. “Why did you think 30 year T-Bonds had to pay double digit interest rates in the early 80s?”

    The didn’t have to. The Fed pushed up the Fed Funds rate to fight inflation. The long term rates are derivative of the Fed Funds rate. The government really doesn’t need to sell T-bonds at all, so whatever the “market” says is meaningless to the government.

    It can pay any interest it wishes, at the press of a computer key.

    As I said earlier, if you’re afraid of inflation, buy TIFS, and you’ll be fully protected.

    Remember, the federal government is not like the states, counties, cities, corporations, you or me.

    “True as long as you ignore that inflation is a consideration of a conservative investor”

    Sure it’s a consideration, but there is no risk of default, which is what the subject was. Buy TIFS. They won’t default, and will solve the inflation problem.

    Rodger Malcolm Mitchell

    • So according to you everything is fine and dandy!!! Why should we pay taxes when the Fed can buy all debt the government needs to issue and the Fed is guaranteed to get its money back because the government will never default? To me it sounds like pure banana republic talk, perhaps an evidence of global warming, since the parallels of those republics seem to be moving northwards even at a faster pace than the glaciers are melting.

      And by the way if you think that paying back debt with paper that has lost its worth is not a default, then I guess there is little more to discuss, since we obviously do not speak the same language.

      • Ah, classic young debt hawk. Lot’s of ridicule, sneering and straw men, but as usual, no supporting facts.

        No, I never said, nor believe “everything is fine and dandy.” And your statement about our not having to pay taxes because the Fed can buy debt is nonsensical. Taxes have zero relationship to debt. (See: Debt vs deficits)

        And as for paying back debt with paper that has lost its worth, consider this;

        You buy a car for $25,000 on a zero APR, 5-Year note. For sixty months you pay the note, every payment on time. At the end of the five years, your finance company tells you, you have defaulted. What??!! The reason: there has been inflation, so the $25,000 is not worth what it was, then.

        Do you agree you have defaulted?

        Rodger Malcolm Mitchell

      • @Rodger M&M “Ah, classic young debt hawk.”

        Thanks for the young part but I do not see myself in this issue as a “debt hawk” but only as a perhaps bit old fashioned citizen who likes the general principle or fiction that a government should work with taxes and if they need some debt to tidy them over that debt should be repaid to the citizens. You see, I come from a country where as a citizen I am oil-cursed since more than 90% of the nation exports goes directly into government coffers and I would hate seeing my US citizen colleague having to fight the printing-press curse… it is bad enough having to fight the “safe-haven curse.”

        And beware I am not yet formally accusing you of the baby-boomer behavior of “après moi le deluge” but I might get to that.

        And as to whether I agree with having defaulted on your 25.000 example…Of course not! Whatever inflation loss the car financier suffered was most probably included in the 25.000 price tag, and if not… his bad luck or his bad foresight.

  12. So what are you more worried about, inflation or a federal default? If inflation has you concerned, buy TIPS. Then, you’re fully protected.

    As for actual default, forget it. The only way that could happen would be for an unimaginably stupid Congress to keep the debt ceiling so low, the Treasury is unable to create money.

    (Even then, the Treasury could create money, simply by creating money.) Increasing the debt is not necessary for creating money. Currently the Treasury creates T-securities (aka “debt”) out of thin air.

    It just easily could create dollars and stop creating T-securities. This would provide an end run around the meaningless “debt ceiling.”

    Rodger Malcolm Mitchell

  13. Yes, nothing is risk free. In order of risk, from less to more risky:

    1. The Tea Party will say something knowledgeable
    2. The U.S. will default on its bonds
    3. A giant meteor will destroy Washington, DC

    So, the risk falls somewhere between those three unlikely occurrences.

    Rodger Malcolm Mitchell

  14. Re, OTC’s &CCP’s paper posted today….. using a “privacy pool” to compile the different country capital in an OTC buffer, then cash swaps to the private sector may improve the central bank/CCP method enough to avoid taxing to prevent “over-submital” to the proposed OTC market (for international capital reserves?)

  15. A not so simple simple question to the IMF:

    If banks, by means of capital requirements based on the perceived risk of default are given special incentives to go to where officially the risks are perceived as low and to shun all what is officially perceived as risky… is it for the rest of us, meaning individuals with lesser financial expertise, to pick up the responsibility for taking the risks a society needs to take in order to move forward? Or are we just all suppose to stop moving forward and submerge?

  16. “Regulators could also assign them a non-zero risk weight under the standardized approach and suddenly these bonds are not risk-free rates any longer”

    Is this where reality hits the desktop of a bureaucrat or where the desktop of a bureaucrat hits reality?

  17. [...] Bonds: No Longer a World Without Risk By Amol Agrawal José Viñals of IMF writes this superb post on the [...]

  18. [...] looks like the IMF has finally gotten the memo, declaring in a blog post that government bonds are not the risk-free asset they once were. The main implication being that sovereign paper now assumes the characteristics of [...]

  19. The PIIGS soon will default. So does that mean government bonds are risky? That depends.

    It depends on whether the nation is Monetarily Sovereign (as is the U.S.) or monetarily non-sovereign (as are the PIIGS).

    A monetarily sovereign nation has the unlimited ability to pay its debts. So, U.S. bonds are 100% without risk, unless you count inflation. Buy a $1,000 T-bill and you will receive $1,000. Yes, inflation can be an issue, but it always has been. No change there.

    Of course you can buy inflation adjusted bonds, in which case even inflation would not be a risk.

    There remains one risk: If an insane Congress refuses to raise the debt ceiling, and forces the U.S. to default on its obligations. Since there is zero reason not to raise the debt ceiling (or even to have a debt ceiling) it would require a monumental act of ignorance, for this to occur.

    Rodger Malcolm Mitchell

  20. [...] IMF realises that government bonds aren’t [...]

  21. The transparency of “the 12 compliances of ROSC” as a set of compliance ratings added to Article IV assessments seems far superior to the triannial survaillence method being presently discussed. A published methology for the 12 compliance with a legal rating method (country’s interpretation of methology is agreed to or not), I would believe is the universally accepted method to rate with.

  22. @José Viñals: “One thing is now very clear: government bonds are no longer the risk-free assets they once were”

    Objection! Government bonds have never ever been risk free assets. Some financial models might have used that concept in order to simplify or establish benchmarks, but it was only some bank regulatory fools who actually considered them to be risk-free… and with their scared-of-risks regulations, helped to make their issuance excessive… which leveraged their initial low riskiness into truly monstrous dangers.

    • Aside from inflation, U.S. T-securities are 100% risk free.

      Rodger Malcolm Mitchell

      • Excuse me, what is that of “aside from inflation”? If the US debt cannot be served it will most probably not be recognized by any formal default but precisely by the watering-down effect of inflation.

      • ok. what will happen IF US economy collapse? will the bonds still be recognized?

      • The hardest question for an investor right now is not whether to have a haircut, but where to have it.

        Who knows, when push comes to shove the market might even go for a crew-cut and accept Dollar II obligations in payment of the current US Dollar I obligations.

    • You say government bonds, but I assume you are talking about treasury bonds.

      Let’s make it clear; nothing is risk free. However US Treasury Bonds were damn near and are still the closest you can get to a risk free return to typical investors in the market place.

      These ‘fools’ who determined that Treasury Bonds are almost risk free did so because the US Gov’t has NEVER DEFAULTED on a Treasury Bond. NEVER.

      Your assumption that Treasury Bonds were never considered close to risk free is false; even the most conservative of investors have always considered Treasury Bonds to be virtually riskless when it comes to default.

      • “even the most conservative of investors have always considered Treasury Bonds to be virtually riskless when it comes to default”

        True as long as you ignore that inflation is a consideration of a conservative investor” Why did you think 30 year T-Bonds had to pay double digit interest rates in the early 80s?

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