July 31, 2014

Do Bond Markets Underestimate the True Riskiness of U.S. Treasuries?

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The ultra-low interest yields on U.S. Treasury bonds seem to suggest "not much." Some of this is because relative to the fiscal positions of other countries, the U.S. economy seems relatively more capable of supporting the public debt. But it may also be because the pricing of government bonds is less an efficient reflection of the inherent market riskiness of the bonds than it should be. According to a former Moody's analyst, bond rating agencies currently do not rate public bonds using the same kinds of objective measures used to rate private bonds, possibly understating the true risk in holding U.S. Treasury debt. 

Bond markets appear to be pricing Treasury debt as if it is risk free. However, if fiscal imbalances are not resolved, bondholders face the risk of losing value due to inflation and could suffer an outright default. While these risks are minimal in the short term, 30-year Treasury bond investors receiving sub-3% yields are not being compensated for the risks they are shouldering. Meanwhile, U.S. policymakers are only encouraged to keep deficit financing additional spending and tax cuts, because deficit financing seems nearly "free" compared with the alternative of proposing offsets (revenue increases or spending cuts) which have obvious costs.

But deficit financing is not free, and under-valued risk via low interest rates is just as unsustainable as the path of rising debt. Unfortunately, the market signal of higher interest rates may come only too late and too suddenly -- via a "tipping point" -- to effectively guide our fiscal policy choices.

Just how safe does the U.S. national debt look under more objective measures of its riskiness? How would a bond rating agency evaluate Treasury bonds if they consulted the same types of analyses often used to rate private bonds? Former Moody’s analyst Marc Joffe has developed a "Public Sector Credit Framework" designed to answer this question and raise public awareness of the national debt problem more generally. The Concord Coalition highlighted Marc’s work in a July event on the Eurozone crisis and implications for the U.S. economy and fiscal outlook.

One measure of private credit market default risk used by rating agencies is the ratio of interest costs to income. Applying this standard to the U.S. federal government’s financial situation, Marc simulated the paths of U.S. federal interest payments and federal revenues (based on Congressional Budget Office data) to illustrate the risk of a U.S. federal "fiscal crisis." Based on a "crisis point," defined as interest payments exceeding 30 percent of revenues, Marc found a greater than 50-50 chance of a U.S. fiscal crisis by 2040, although there is only a 10 percent chance the threshold will be crossed within the next 10 years -- as illustrated in the chart below.

Following the Eurozone event, Marc and I sat down to talk about his model and some of the perhaps surprising results of his applying the framework to the fiscal outlooks of other countries. You can watch our conversation in the video here.