If you ask most investors what assets they hold, the overwhelming majority of investors, and most likely their assets, are invested in stocks and bonds. These two commonly traded assets are easy to buy through brokers and retirement plans, are traded on exchanges, and are generally easy to liquidate. And with decent historical returns, there\u2019s a reason they\u2019re so popular with so many investors.<\/p>\n
The theory behind them seems pretty sound too. Stocks are a share of ownership within a company. Some companies pay a share of profits to shareholders in the form of dividends. And as the company grows in value and increases in performance, the share price often increases, providing a benefit to shareholders when they decide to sell their shares.<\/p>\n
The theory behind bonds is similarly simple. You pay money to buy a bond, you receive interest payments periodically, and a return of your principal when the bond matures. Nice and easy, except when the bond defaults. That\u2019s why many investors try to choose bonds with minimal default risk. But one popular bond beloved by investors may actually be riskier than it seems.<\/p>\n
When it comes to investing in bonds, the presumption on the part of investors is that those bonds will eventually mature and be bought back by the issuer. The assumption is that the issuer of the bonds eventually wants to eliminate or draw down its debt over time. But what happens when the issuer has no plans to reduce or eliminate its debt? What happens when the bond issuer continues to roll over debt, and eventually issues new debt to pay the interest on its older debt?<\/p>\n
That\u2019s a problem we\u2019re seeing increasingly in the United States, as zombie companies are multiplying at a great rate. Zombie companies are those whose income is only able to pay interest on their debt, but they\u2019re not able to repay their principal. At some point these companies become victims of their precarious financial situation, unable to service their debt, forced to issue more debt in order to pay interest, and eventually they have to declare bankruptcy. There\u2019s one debt issuer in particular that has become quite a risk, but it\u2019s not a company \u2013 it\u2019s the federal government.<\/p>\n
US Treasury securities are considered the gold standard when it comes to investment in sovereign debt, considered almost a risk-free asset. Anytime you even bring up the topic of default, you\u2019re hit with the argument that the US government couldn\u2019t possibly default on its debt because it\u2019s backed by the full faith and credit of the US government. But what does that really mean?<\/p>\n
At over $28 trillion, the US national debt is more than seven times larger than annual tax revenue. And the debt size surpassed US gross domestic product years ago, making the federal government\u2019s debt larger than the entire US economy. A debt that large can only mean one thing: it won\u2019t ever be repaid.<\/p>\n
Even the interest on the debt is growing, with the government spending over $500 billion a year on interest expense. There\u2019s no serious attempt to pay down the national debt, and recently it has begun to increase by trillions of dollars each fiscal year.<\/p>\n
With so much debt issuance, it should be clear that the national debt will never be repaid. Default will occur at some point, it\u2019s just a matter of when and how. The most common method of default is that of inflation, in which the government pays back investors with depreciated dollars. With inflation rising in recent months, that could become a problem for more and more investors, particularly with interest rates on government bonds being so low.<\/p>\n
The other method of default is an outright default, which can\u2019t be ruled out completely. That means that those who invest in US Treasury securities have to worry about whether they\u2019ll even receive a return of their principal.<\/p>\n
Everyone who holds Treasury securities today hopes that they\u2019ll be able to sell their Treasuries before the government defaults on them. They assume that they can hold Treasuries until they need to sell them, and that there will always be a willing buyer for them. It\u2019s the \u201cgreater fool theory\u201d in action. But what happens if there are no buyers, or if so much Treasury debt is issued that buyers only want to pay pennies on the dollar?<\/p>\n
That means that investing in Treasury debt might not be the risk-free option that many people would like to make it out to be. At some point the music will stop playing and everyone holding Treasuries is going to be out a bundle. But in the meantime, investors continue to treat Treasuries as though they\u2019re a risk-free asset, which could be dangerous to their portfolios.<\/p>\n
The thing about sovereign debt crises is that they often manifest themselves very quickly. If you think it will be 20 to 30 years before the US government faces a sovereign debt crisis and you think you can continue to hold large amounts of US Treasuries without consequences, you may face a rude awakening at some point in the future.<\/p>\n
More and more investors are waking up to the reality that the US government won\u2019t ever repay its national debt, that it will continue to move itself further and further into debt, and that there\u2019s an increasing likelihood that the \u201csafe\u201d assets they hold today could become toxic in the future. US Treasuries may be considered a safe haven asset today, but in the future they could become an asset for suckers.<\/p>\n