The Assumption is US Government Bonds Are “Risk Free”

Estimated Reading Time: 5 minutes

Unless one is familiar with portfolio theory, you may not be aware that for many discussions, and for many strategies, US Treasury Bonds are considered “risk-free”.  Therefore their “risk-free” return is used as a lodestar to assist in comparing investment strategies.

For example, in many decisions, investors must look at the trade-offs (what is the risk, and what is the return) of any given decision.  The point of comparison is often the yield on “risk-free” US Treasury Bonds.

Here are two quick examples:  suppose for the sake of argument that the “hurdle rate” on real estate rentals is 5%. Investopedia defines the hurdle rate as: “A hurdle rate is the minimum rate of return a project or investment must achieve before the manager or investor approves a predetermined condition. It allows companies to make important decisions on whether or not to pursue a specific project. The hurdle rate describes the appropriate compensation for the level of risk present—riskier projects generally have higher hurdle rates than those with less risk.”

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With short-term US Treasuries now above 5%, it may now be equal to, and about to exceed, the hurdle rate on the project anticipated.  That real estate return comes with all the normal risk and given today’s environment, even abnormal risk.  You could have cost overruns, shortages of labor, and supply chain problems, may not be able to rent the units, you could run afoul of regulations, and you could get sued. You may have to pledge personal assets to get a loan.  So, if an investor can get in excess of 5% with little or no risk at all, why engage in taking business risks?  The return might be nearly the same, but there is a huge difference in risk.  The “risk-adjusted” return on short-term treasuries begins to look attractive in comparison to the hurdle rate of a given business undertaking.

Let’s assume another scenario:  You and the wife are thinking of buying a large motorhome and touring the country for a few years as part of your retirement dream.  You hope to spend at least three months a year on the road. The motorhome is expensive to maintain, to insure and is a depreciating asset. It costs $350,000.  There is another concept to absorb, opportunity cost.  This is basically the cost of an opportunity foregone.  With “risk-free” Treasury bonds yield rising sharply, at some point, the math may not make sense.  For example, the interest that could be earned say on a 5.5% Treasury on $350,000 is $19,250 and there is a “guarantee” that at the end of say two years, you get all your money back, courtesy of the US Government.

Let us assume you can find very suitable alternatives like Airbnb housing or motels near the locations you wish to visit averaging  $175 per night.  The interest you might earn would fund 110 nights, more than the 90 you planned for, and you get all your money back when the bond matures.  You are very unlikely to get “all your money back” from a used motorhome that you might drive for say, five years.  So, if you want to see the country, why would you buy an expensive motorhome?  Maybe buy a cheaper one or not one at all.

Now one can argue about the assumptions used in these two examples.  The point we are making, however, is that at some given level of interest rates, the rising yields on safe Treasury Bonds and Notes begin to change the equation for both business and consumption decisions. 

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Exactly where that point is varies with each situation, but at some point, it influences a large number of decisions, and the economy is badly hurt.

Unfortunately, it looks like the situation is likely to get worse. The money necessary to fund our government is rising very rapidly and so are interest rates.  Just since the debt ceiling battle concluded last June, the government has added an astonishing $3.4 Trillion to the national debt.  That has to be funded by selling more bonds.  But as we have pointed out in previous articles, traditional buyers like Social Security, the FED, the Chinese, and the Saudis, are reducing or actually selling out their bond positions.  This has caused weaker bond prices, or rising interest rates, even as the FED said they would “pause.”

The government can borrow and moreover, it can print the money to satisfy its creditors and it can print the money it needs to finance the rising cost of borrowing.  No one in the private sector can do that.  The government grants itself this monopoly on money.  In so doing, at some point, as rates rise, it sucks money like a giant vacuum cleaner away from investing and consumption.  This “crowding out” can cause the economy to slow because money no longer flows into productive endeavors, it simply flows to fund the ever-growing debt of government.  And as explained above, choosing to park in Treasuries as opposed to engaging in enterprise, slows the economy.

Interest rates are rising rapidly.  Even after the most recent FED meeting where they “paused”, rates in the free market have pushed higher by almost one-half percent.  Is the FED beginning to lose control of rates?  It would seem that the supply of bonds is overwhelming demand, and rates are now moving higher, even if the FED does not want them to.

Moreover, we suspect that rising rates are now at an inflection point where the yield on Treasuries begins to look like a safer bet than a risk-taking enterprise.

This could cause a recession, and typically rates fall once credit demand in the private sector collapses.  But collapsing credit demand in the private sector is a huge cost for all of us to pay to fund our runaway government. It gets funded and we don’t.

Our worry is the financing costs for a welfare state government go up rapidly in a recession.  Revenue coming into government coffers falls (fewer people are engaging in enterprise to be taxed), and social welfare spending explodes because formerly employed people fall into the “social safety net.” 

Various industries important to the government will cry out for bailouts. Revenue falls, expenditures rise, and deficits rise even faster, which causes the issuance of more bonds, which could conceivably cause rates to actually rise in a recession!  It is a debt spiral that has gotten out of control.

And of course, this could cause one other problem.  While all of us are hiding in Treasury Bonds based on the valid assumption that they are “risk-free”, we discover they are not risk-free.  The government itself is now in danger of default.

Nonsense you say, the government can print the money to pay its bills.  They can’t default.  That is true.

However, that means that bondholders get defrauded through currency inflation. They lent the government 100 cents on the dollar in current purchasing power, only to get back say 80 cents after a few years of high inflation.  If bonds become “certificates of confiscation” (that was a term used during the 1970s double-digit inflation), then the government gets funded alright… to the detriment of everyone else in society.  We all pay higher interest rates, we take less risk to grow the economy, there is less credit for everyone because what is available goes into the sucking maw of government, and we all lose purchasing power on savings and investments.

This is not a healthy train of events!  Consumers get squeezed between higher costs of borrowing, higher oil prices, and higher prices for everything else.  The government performs a “stealth default”, by reducing everyone’s standard of living and economic opportunities below what they otherwise would be if the government had behaved itself.

The reason they get away with this game is voters see the benefits of government spending and deficit-financed programs, but can’t really calculate how much it is costing them in terms of their standard of living.  It is kind of hard to know what you “could have had.”

There are many other implications of rising rates to be explored.  In that regard, the two following videos are worth your time viewing, and then thinking about.

 

Image credit: Shutterstock

 

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