Friday, July 22, 2011

In Case of Default, Buy Treasuries?

In life there are many things that do not make sense. Why does it sometimes rain when there is nothing but blue sky and sun? Why would the U.S. government ban online poker when they are seriously in need of revenue? Why do dogs hate cats? Why would Treasuries go up in price if/when the U.S defaults on its existing debt? (Read this again in case you were busy drinking coffee/reading other articles/playing a game/playing two games while drinking coffee.)
      I read an interesting article today (@CNBC) that proposed that exact, seemingly ludicrous, (not the rapper) idea. Before you close the blog page and write me off as a loony let me explain what amounted to two valid arguments made in the article.
        First, There is an insatiable desire for U.S. treasuries. China, Japan, Europe, Money Market funds, and large corporations all hold U.S. treasuries for security and yield (however minimal it is) because they are considered the same as cash except with a yield. Imagine for a second that I told you that money you put under your mattress earned X% interest annually. Now stop imagining and by treasuries because that is how the global market place views them. When the U.S. hits the debt ceiling (I keep saying when so you obviously know how I feel about the likely hood of compromise occuring between politicians.) it will no longer be able to issue new treasuries. In Economics 101 we all learned that when supply goes down and demand stays the same price goes UP.
       Second, Whenever people get spooked by anything they always run from risky assets and fly to safety. The flight to safety is generally U.S. Treasuries. I'm sure all you amateur Sherlock Holmes' and Cam Jansens' (#childhoodmysteryprotaganist) can see where I am going with this. Where do you run if what you are running from is what you normally run to? The answer is simple (is it?) you run to your broker and buy some Treasuries. I have to admit I find this argument to be a little more suspect than the first, but it does bring up a valid concern. If the whole world is collapsing around you then where do you go for yield? I suppose you can argue that if the whole world is collapsing around you that yield is not as important as a supply of food and weapons, but for the sake of discussion lets say that just the European and U.S. bonds are in default. You aren't going to shove your money in stocks because they are termed "risk assets" and you aren't going to put your money in the bank because you need to earn some return. I'm sure everyone remembers the classic cure for a hangover in college? A beer when you wake up. I guess when people say that Investment Firms are like fraternities they really aren't far from the mark.
      I will not say that I completely agree or disagree with this article but I will say that it is intriguing. How would you allocate your investments in the event of a U.S. debt default?


  1. The affect on the US Treasurys increasing their default risk is a major threat to money managers and not so much to the retail/individual investor. There can be profound affects to the likes of pension funds that must carry triple-A rated securities, those that use LIBOR, financial models, including CAPM which generally use the US Treasury as RFR, and many more examples.

    Will the price of US Treasurys increase steeply? Not likely. Sensibly the required rate of return/interest rate would increase sending the value lower. Investors would still value US debt highly over other sovereign debt.

    To answer the question of where I would put my money, I would likely take some money off the table for my fixed income portfolio and allocate more to equities.

    Scott Roth

  2. I agree with everything that you said here. I didn't consider The effect that a U.S. default would have on the RFR (risk free rate). For everyone who doesn't know, RFR is used as part of a calculation to decide if you are getting adequate return on an investment or if you would be better off just buying a "riskless" assest such as a U.S. treasury. (It might be time to use Microsoft corporate debt with 30 year as the RFR.)
    The one part of your post that I disagree with is your asset allocation post default. I am fine with taking money off the table, but I don't think I would allocate extra money to equities because we would be in a "risk off" environment. I think the best place to be would probably be high grade corporate bonds and cash. The cash is important for buying equities once there is an inevitable correction (at least 10%).