Safe assets are a dangerous delusion (source here)
It is an almost ubiquitously held view that government bonds in rich countries are safe investments, meaning that defaults are impossible. Journalists, analysts, academics, and policymakers habitually refer to government bonds in rich countries as "risk free assets" with the same arrogant certitude as one would long-established facts, such as the existence of gravity, the theory of evolution, or that the earth is round. Whenever members of the finance industry say the words "risk free rate" you can be sure they are talking about the yield on a rich country's government bond, usually US Treasuries. Sceptics who dare to question the safe asset orthodoxy are often dismissed as complete idiots.
The only problem is that there never has been nor will there ever be such as thing as a safe asset.
For starters, the risk free rate is a purely theoretical concept (see Endnote 1). In the real world, no one would offer to pay interest to borrow money if the investment is completely risk free. After all, the supply of funds would be infinite, so the borrower could drive the rate of interest down to exactly zero. The reason why government bond yields in the real world are not zero is that there are in fact many risks out there, not least inflation and credit risk. Yield curves, which describe the relationship between time and the interest rate on bonds, is upwards sloping under normal conditions, because these risks rise with duration (see chart below).
A normal yield curve (source: here)
Why is investment always risky? Investing is risky, because it is fundamentally an inter-temporal activity. An investor parts with a specified sum of money today in exchange for a stream of future cash payments. It does not matter how firmly the government of today commits to future debt service, the future is inherently unpredictable and accidents happen.
But 'accidents' are the least of the concerns facing holders of so-called safe government bonds. The two really big risks associated with investing in government bonds are credit risk and inflation and they apply to rich and poor countries alike.
First, consider inflation risk. Proponents of 'safe' assets are quick to argue that governments would never deliberately choose to default as long as they can print money to service the debt. However, this argument is disingenuous for two reasons.
For one, there are actually well-known examples of countries that have defaulted on domestic local currency-denominated debt in spite of being able to print money. In 2023, defaults on Emerging Markets (EMs) local currency sovereign debt increased significantly to US$13.7 billion from US$275 million in 2021 (see here). Clearly, the mere fact that a country can issue in its own currency does not in itself preclude defaults.
Secondly, printing money can lead to inflation, which is just default by another name. Inflation may not involve an explicit breach of the terms of a bond prospectus, but from an investor's perspective it is almost irrelevant whether he loses half of his investment through a conventional default or sees the real value of his investment halved by inflation. I say "almost" because some investors might actually prefer outright default to inflation, because at least they get their day in court.
Inflation is unambiguously the default of choice for rich countries. Take the case of the United States in the 1970s. During this decade, inflation averaged 8% per year and real yields on US Treasury bills were negative for much of the decade (see chart below).
Real yields on US Treasury bills were negative for most of the 1970s (Source: Boston Fed, here)
Due in large part to high inflation, the US Dollar lost 43% of its value against the Deutschmark and the Japanese yen between 1969 and 1979. The combination of negative real rates and the plunging currency made the 1970s a less than amusing period for investors in US Treasuries, especially foreign investors.
What was actually going on during this time was that US monetary policy was deliberately calibrated to inflate away the large debts accumulated by the US government through 'Great Society' spending under Lyndon B. Johnson and the Vietnam War. Over-easy monetary policy effectively transformed American debt into American inflation. American inflation in turn inflicted enormous losses onto the foreign central banks that had financed the American spending boom by buying US Treasuries. Once the debt-to-inflation transformation had been completed, Federal Reserve Chairman Paul A. Volcker was able to kill off inflation with sharply higher rates in the early 1980s without inflicting too much damage on the US economy, since the size of the debt stock was now much reduced in real terms.
While we are on the subject of inflation, proponents of the safe asset delusion like to argue that bond market volatility, say in response to a perceived risk of higher future inflation, is perfectly harmless trader fun! For a recent example see here. They argue that spikes in bond yields observed during bond market sell-offs are just the result of investors merrily switching between fixed and floating rate bonds within their portfolios.
But is this rosy view really true? Take the relatively recent sell-off in UK gilts that followed former Prime Minister Liz Truss's disastrous budget proposal of September 2022. This episode - depicted in the chart below - was nothing other than a banal arbitrage between floating and fixed rate bonds, according to the safe asset delusionists.
Source: here
Yet, if the sharp spike in 30-year bond yields to above 5% was really just an innocent arbitrage then why did the Bank of England have to intervene to save the British pension system? Why did stock markets crash? Why did the Great British Pound plunge to an all-time low versus the Dollar? And why did all these developments reverse once Truss was gone and her budget proposal had been ditched?
I will concede, of course, that arbitrages between fixed and floating rate bonds take place all the time in the UK gilt market during normal market operations, but there are at least three reasons why it is misleading to dismiss all bond market sell-offs as harmless arbitrages, even in rich countries:
The first reason is that the sustainability of any given stock of government debt declines as rates rise, regardless whether the rising yields are floating or fixed. As debt sustainability worsens, it becomes more and more expensive to refinance old debt and raise new money as each bond issued at a higher yield locks in years of higher future repayments, depending on the tenure of the bond. Higher real yields also have negative secondary ramifications for fiscal sustainability through their impact on economic activity; higher borrowing costs mean lower levels of economic activity, which in turn reduces tax revenue and increases statutory spending, such as unemployment benefit.
Second, it is not always desirable to issue new bonds during periods of stress, even when it technically possible to issue, say, with a floating rate. When a government chooses to issue a new bond during a period of market stress, it tacitly admits to being in trouble. This alone can trigger speculative attacks that only make market stresses worse. Clearly, a government with comfortable finances opts never to validate temporarily elevated yields by issuing new bonds at such times. Instead, it postpones issuance until yields have once again returned to levels deemed to be commensurate with the government's own perceived solid willingness and ability to pay.
Third, floating rate bonds are not perfect substitutes for fixed income bonds. Floaters have never comprised more than about 30% of the UK gilt market and as of the end of 2023 floating rate UK gilts, usually referred to as index-linked bonds, comprised less than 25% of the UK gilt market (see chart below).
Source: here
Why does the composition of outstanding bonds even matter? Because institutional investors measure their performance against an index, which only changes very slowly. Hence, if an institutional investor suddenly has to switch, say, half of his investment from fixed rate bonds into floating rate bonds then he ends up with a huge off-benchmark bet on floating rate bonds, often acquired at elevated prices. If the now-very-active bet on floaters versus their small benchmark weight turns out to be a bad one, say, if the investor gets his timing wrong, then he faces immediate and serious career risk. For this reason, institutional investors tend not to make big off-benchmark bets (which is why they are sometimes referred to derogatively as 'index huggers'). In practice, therefore, big switches from fixed rate bonds to floaters will actually never happen, even if such a trades can make good sense if managed properly.
The discussion of fixed-to-floating rate arbitrages brings us neatly to the other big risk facing investors in government bond markets, namely sovereign credit risk. Governments - be they rich or poor, authoritarian or democratic - are replete with principal-agent problems. Politicians do not manage their own money; they manage tax payers' money. Since politicians' incentives may not be identical to those of tax payers conflicts of interest between principal (the voters) and agents (politicians) are unavoidable, particularly as politicians are put in charge for several years at a time and, once elected, are basically free to do more or less what they please, for a time at least.
Thankfully, many politicians take a long view, at least as far as debt service is concerned. But others care far less about debt. Some pander to interest groups. Others are populists with very high rates of time preference, who strongly favour consumption over long-term stability. Some governments end up being run by people with very big personalities and very small brains. I would not rule out that a future anti-establishment US president, say Donald Trump II, suspends debt service solely with the aim of hurting a large foreign holder of US Treasuries like China.
Institutions can also become a source of sovereign credit risk. Take the US Congress today. Polarised and sometimes outright dysfunctional, the House of Representatives could trigger a default on US Treasuries simply by failing to reach agreement to raise the US debt ceiling on time. It would not even require anyone to actually want to default!
Since these types of sovereign credit risk are intrinsic to the operations of governments and therefore entirely universal they do not depend on the country's level of per capital GDP. Laws of economics determine if and when governments default and they apply equally to all countries. The types of risks involved in investing in government bonds are exactly identical regardless whether the country is rich or poor (see Endnote 2). The only difference between one country and another is the weight assigned to each type of risk.
So rather than resort to crazy quasi-religious postulates or articles of faith about so-called safe assets, it makes far more sense to explain observed differences in default rates between rich and poor countries in terms of structural, regulatory, and institutional differences.
I would argue that there are five major structural, regulatory, and institutional differences that explain why government bonds in rich countries default less often than government bonds in poor countries.
First, some EMs issue bonds in foreign currency, while rich countries tend not to do so. EMs issue foreign currency bonds, because some do not yet have well-developed domestic savings institutions such as pension funds to which they can issue in local currency. Foreign currency denominated bonds are more prone to default, because countries can run out of foreign currency, even if they are technically solvent. However, it is important to recognise that foreign currency debt is actually a small and shrinking part of the EM bond universe; more than 80% of EM debt is now denominated in local currency (see table below). A EM country such as Thailand does not even issue external bonds.
Second, richer economies are naturally less vulnerable to shocks than poor countries by virtue of being more developed. Higher levels of income imply larger buffers to draw upon before a crisis becomes critical to survival. Richer countries also have more diversified economies, with wider tax bases and more evolved financial systems, including larger pension and insurance industries, so they are more resilient to external and domestic shocks.
Third, regulation favours issuers in rich countries over poor countries. In fact, the global regulatory system operates a de facto financial apartheid system in which bonds issued by rich countries are given a zero risk rating, while bonds issued by poor countries are given non-zero ratings. A zero risk rating is fundamentally inconsistent with the reality that risk exists everywhere. Moreover, it amounts to a financial subsidy for issuers in rich countries. The zero risk rating means that banks and institutional investors are able to hold government bonds issued by rich countries without setting aside capital to cover potential losses. By contrast, investors are required to set aside sizeable amounts of capital to cover potential losses when they invest in bonds issued by poor countries. Moreover, since the cost of the risk buffer rises when market interest rates rise, banks and institutional investors face strong incentives to off-load their bonds from poor countries and to load up on bonds of rich countries during bouts of market volatility. This asymmetry tends to amplify the volatility of poor country bonds and lowers it for rich country bonds, not because such price action is necessarily warranted by fundamentals, but solely because of the biases built into the regulatory system.
Fourth, the three big ratings agencies (Standard & Poor's, Moody's, and Fitch) tend to punish EMs far harder than developed economies when they have bad economic news or make policy mistakes. The reason why ratings agencies favour rich issuers is extremely simple: the rating agencies are paid by issuers and since rich countries issue far more bonds (which is why they are far more indebted) they are much important clients to the ratings agencies than EMs. Ratings agencies, being private companies, naturally look after their bigger clients in rich countries better than their smaller less important clients in EM. In practice, this is why developed economies are downgraded far less frequently and by less than EMs.
Finally, bonds in poor countries are much less well-represented in benchmark indices than bonds from rich countries. I already made reference to the importance of benchmark indices in the discussion of floating and fixed rate bonds in the UK gilt market. In EM, the problem is far worse. Only about 10% of outstanding EM bonds are formally represented in global benchmark indices compared to almost 100% for bonds in rich countries. The reason for the gross under-representation of EM bonds in benchmark indices is so banal as to be almost bizarre; it is because the index providers - big investment banks - only have market-making offices in very few EM countries. The big banks only obtain the daily pricing data they need to populate their indices if they actually make markets in the specific markets for local securities. Unfortunately, the big banks have very few market-making branches in poor countries, and, hence, extremely poor index coverage. Clearly, the provision of benchmark indices is a public good, which ought to be done by global institutions, such as the International Finance Corporation, the World Bank, or the International Monetary Fund (for a discussion of this issue see here).
Anyway, the point is that index-hugging institutional investors - the largest and most stable investor base in the world - invest very little in EM due to low index representation for poor countries. Moreover, to the extent some of them actually want to hold more EM bonds than the low index weight they are forced to take significant benchmark risk, which most of them then end up unwinding in a great big hurry during market stresses, increasing the volatility in EM financial markets.
In conclusion, there is no such thing as a safe asset. The mind-numbingly stupid and irresponsible practice of referring to rich country bonds as safe assets only serves to reinforce stereotypes about investing in rich and poor countries. Stop doing it!
Having said that, it is always important to remember that it is not actually default rates per se that matter from an investment perspective. Rather, what matters is whether investors are paid adequately for the risk. In this respect, there is no doubt where investors should put their capital. The risks associated with investing in government bonds in rich countries are clearly underestimated, entirely ignored, in fact, while the risks of investing in EM government bonds tend to be chronically exaggerated. By shifting funds from developed markets to EM, investors can therefore both reduce risk and increase return over time. Indeed, in the long run investing in EM bonds has proven far superior to investing in developed market bonds, both in absolute and in risk adjusted terms. The good news for EM fans is that this state of affairs looks set to continue as long as most investors continue to suffer from safe asset delusion.
The End
Endnotes:
The theory of the risk free rate: One theory states that the risk free rate is the rate at which the return on capital equals a representative consumers' rate of time preference in highly stylised non-stochastic models of economic growth. The rate of time preference, which is both subjective and exogenous, describes the consumer's preference (read impatience) for consuming today versus consuming tomorrow. Due to their impatience to consume, consumers can only be induced to postpone consumption if the opportunity cost of consumption - the risk free rate of return on capital - is at least as high as their rate of time preference. In equilibrium, the risk free return on capital therefore converges to the rate of time preference. Accordingly, impatient societies end up with higher equilibrium risk free rates of return, while patient societies have lower equilibrium risk free rates of return.
Sovereign defaulters: No country in the world has defaulted more than Spain, a developed economy, albeit Spain has not defaulted since the 19th Century. Another developed economy, Greece, was recently responsible for the largest ever default in bond market history (more than USD 375bn). Greece also defaulted on its debt to the IMF, a rarity. Still, as mentioned above, rich countries mainly default on government debt through inflation and currency debasement.