Are Government Bonds the New Subprime?

Are government bonds the new subprime? That's what Financial Times assistant editor Gillian Tett asked in a column on Monday. On the face of it, the question looks absurd -- surely there is no comparison between shaky loans to weak borrowers and securities backed by the full faith and credit of the U.S. government. Unfortunately for government bond investors (and taxpayers), it's possible -- useful, even -- to make the rapprochement between these two assets. Here's why, and what investors should do about it.

New financial regulation should seek to minimize the risks of credit bubbles occurring. Tett's point is that advocating that banks pad their capital with "risk-free" government debt (per the new capital guidelines the G-20 regulators are working out) at a time when the public finances of industrialized nations are rapidly deteriorating could have ugly unintended consequences.

What "risk-free" means
Let's be clear: The risk of the U.S. government reneging on its obligations remains extremely low. Treasury bond owners can be confident that they will receive their interest and principal as promised. However, the purchasing power of those fixed payments on their due date is another matter altogether. At a time when the U.S. has been printing dollars at a furious rate, it's difficult to ignore the specter of inflation.

In his most recent letter to Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) shareholders, Warren Buffett warned that owning government bonds is no riskless enterprise, writing that, "clinging to ... long-term government bonds at present yields is almost certainly a terrible policy if continued for long." Buffett goes on to write that, "the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary [as the Internet bubble of the late 1990s and the housing bubble of the early 2000s]." Is it necessary to point out how participants in the two previous bubbles fared once they burst?

"There is no such thing as bad bonds, only bad bond prices"
That's a terrific quote from James Grant, editor of Grant's Interest Rate Observer, that sums up the notion that a bond's risk can only be assessed in respect to its price. The converse also holds: "There is no such thing as safe bonds, only safe bond prices." If you overpay for a bond -- even a Treasury bond -- you aren't free from risk.

Right now, government bond yields are very low by historical standards; at 3.31%, the yield on the 10-year Treasury is less than half its historical average going back to 1962 (6.90%). If investors' inflation expectations ratchet up, they will require higher yields to own Treasury bonds, whether they are buying new or existing issues. Higher yields equate to lower prices for outstanding bonds and losses and will produce losses for investors who happen to be holding them. For banks that own T-bonds as part of their capital base, this implies lower capital ratios and a diminished ability to sustain loan losses.

A looming problem for banks
Is this really a problem now? On November 11th, Treasury and agency securities represented 11.8% of assets at all U.S. commercial banks, below the average going back to 1973 (13.3%) and much below the maximum ratio achieved in April 1994 (20.2%). That's hardly cause for complacency, however, because 1) these securities are arguably riskier now that at any time during this period, and 2) we should expect that ratio to increase over the next few years.

Source: Author's calculations based on data from company 10-Q reports.

This new font of risk has not gone unnoticed. Activity in the credit default swap (CDS) market, which enables participants to buy and sell insurance on bonds, suggests that investors are paying increasing attention to the default risk of industrialized nations' sovereign debt. The volume of CDS contracts linked to U.S., U.K., and Japanese government bonds has doubled over the past year. One canny investor, David Einhorn (who famously sold Lehman Brothers shares short before its collapse), has bought long-dated options, betting that interest rates will rise in the U.S. and Japan. That's fine, but what should non-professional investors do?

Two options for individual investors
You have an advantage over banks -- you're not compelled to buy T-bonds. I recommend being underweight government bonds at this time; instead, investors should consider hedging their dollar/inflation risk by tilting their exposure to international stocks and reasonably priced dividend stocks.

Current Federal Reserve policy is creating tangible risks for investors. Tim Hanson explains why you need to get out now!