I am retired and take educated guesses on all things financial.

November 23, 2009

November 23, 2009: Is Sovereign Debt Stable?

An interesting point of view was articulated by FT's Assistant Editor Gillian Tett. According to Tett,"It is easy to imagine that some countries will end up eroding the value of their bonds by debasing their currencies." I believe he is correct.

Government bonds of the industrial world are believed to be a top drawer, AAA-rated safe investment. Investors have flocked to them. G-20 regulators are holding meetings in Basel to draw up new rules on how banks should protect themselves from another financial meltdown by investing a greater proportion of their in less risky assets such as stable government bonds.

Tett point out that this flight to safety through the accumulation of government bonds in itself may well be creating investment dangers. Government debt has skyrocketed to levels not seen before. Fiscal deficits are exploding across the western world. Sadly, the level of political commitment to "reign" in the deficits (pun intended) is not present, in large part because the yields are so low as to make borrowing practically free. With low interest, what domestic pressure is there on politicians to reduce debt?

Defaults on government bonds remain highly unlikely. But, there is little doubt that some countries will intentionally erode the value of their currency, and thus the total return of their bonds in the coming years. This almost guarantees igniting inflation.

Major industrialized countries will need to sell more than $12,000 billion dollars worth of government bonds next year to fund their current expense models. This is a rise of over thirty-three per cent over the past two years.

Investors who feel safe earning a miserly interest rate because they deem bond holdings safe will find their game plan ruined by inflation coupled with an intentionally debased currency. This will produce a significantly negative total return. Treasury inflation-protected securities(TIPS) will not be exempt from these type of losses, although at least the interest would rise to partially offset falling currencies.

Granted, there are arguments to be made to counter Tett's premise (deflation, high unemployment so there is not too much money chasing too few goods and services, etc.) but his thoughts are worth considering before the investor purchases government bonds. Receiving,say,70% worth of purchasing power when the investor receives 100% of the government bond at maturity is not the best of investments.

Some ETFs to be monitoring closely include Barclays's BWX, BWZ and WIP, iShares' IGOV, PowerShares' Sovereign Debt PCY as well as all U.S. Treasury Bond ETFs, especially those that are intermediate to long term.

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