Government Bond Yields Reflect More Than Just Default Risk

I’ve said it before and I’ll say it again – we (investors and non-investors alike) need something to worry about. So it shouldn’t come as too much of a surprise that members of the media are questioning the safety of US debt after three Treasury auctions were met with poor demand a couple of weeks ago, mainly from foreign investors. There are a lot of things we should worry about as investors, but the safety of US Treasury debt is not one of them. In the Wall Street Journal article entitled “Debt Fears Send Rates Up,” the reporter points out that during the prior week, U.S. Treasuries were yielding slightly more than U.S. corporate bonds, which is surprising but not unheard of. But her source, an economist at BNP Paribas, brazenly goes on to say that maybe investors are more comfortable with the risks of owning bonds backed by U.S. corporations than the government. This seems far-fetched considering our government just bailed out a number of our country’s most prominent banks and automakers to the tune of nearly a trillion dollars, and given the fact that the US has never even come close to defaulting on our debt. While it is a worst-case scenario, we could simply print more money, unlike many European governments—such as Greece—which depend on the European Central Bank to control the money supply in the Eurozone.

A rising yield for Treasuries, or any developed country’s debt issues, is only occasionally reflective of increased default risk, which is not the main determinant of bond yields and prices. Expected growth, inflation and changes in currency exchange rates are the major determinants of government bond prices; in many cases, they are more important than default risk in pricing a bond. Let’s look at current bond yields to illustrate this point. 10-year U.S. Treasuries and U.K. Gilts currently yield 3.63% and 3.75% respectively, while Japanese government bonds yield only 1.40%. However, according to the S&P, Japan’s credit rating is “AA” while the U.S. and U.K. both have the most secure rating of “AAA.” Whether this is caused by expected appreciation of the Yen against other currencies or assumptions about growth rates or inflation in Japan, it is clear that investors are willing to take a much lower interest rate on Japanese bonds despite their supposed higher default risk.

The decrease in Treasury prices and subsequent increase in yields (since prices and yields move inversely to one another) isn’t something to completely overlook. This could be problematic for the housing market, as it could lead to increased mortgage rates, or could be indicative of other impending problems for the U.S, such as higher inflation down the road. But it certainly does not mean U.S. debt is any less secure than it always has been for many decades.