Bonds: Are They Safe?
With this morning's jobs report broadly in line with expectations, stocks have not done much this morning, with the Dow Jones Industrial Average and the broader S&P 500 up about two points each as of 10:05 a.m. EST.
Is it safe?
In the aftermath of the credit crisis, the whole notion of the risk-free asset has been called into question as government debt loads have increased substantially and economic stagnation does nothing to flatter government debt-to-GDP ratios. Nevertheless, major economies with some of the worst state finances -- the U.S., the U.K., and especially Japan -- continue to enjoy record-low borrowing rates, which suggests a shortage of safe assets.
In a recent paper from the Bank of International Settlements (link opens PDF), the so-called "central bank of central banks," the authors suggest that the problem is not so much a shortage of such assets, "but rather that the definition of safe assets has been elusive and shifting." Recently, for example, the scrips of several European governments have lost that status.
This is not simply a matter of academic debate. Banking regulators decide what constitutes a safe asset for the purpose of calculating the minimum risk-weighted capital ratios banks must comply with. As a result, the stricter Basel III guidelines reinforce the link between banks and sovereigns. As the BIS papers note:
The supply of safe assets has a key impact on the financial sector and the real economy and so the definition of the safe asset universe should not be left entirely to the private sector. The authorities should commit themselves to a clear definition of safe assets and back it with a policy regime that makes those assets credibly safe.
Of course, defining what a safe asset is on a statutory basis is easily done. It's the second part that's hard: backing them with policy that makes them "credibly safe." Unlike banks, individual investors are unconstrained in the way they construct their portfolios and can decide for themselves what constitutes a safe asset. Obsession with the safety of one's nominal principal to the exclusion of all other considerations looks like a short-sighted approach to managing one's assets. Just ask the investors who bought long-term U.S. government bonds in April 1946 (the last time yields were at record lows) -- and suffered a one-fourth loss in real terms over the next decade.
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The article Bonds: Are They Safe? originally appeared on Fool.com.Alex Dumortier, CFA has no positions in the stocks mentioned above; you can follow him @longrunreturns. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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