25 February 2009

The Risk in US Treasuries

One of the lunch regulars, Dave the BondMan, notes to our suprise that the Rate for a Credit Default Swap, the cost of insuring against default, on a 5 Year US Treasury Note is now a full 100 basis points.

The cost of credit default insurance is a real world, market assessment of the risk of default of the U.S. Govt, as opposed to the fantastical ratings issued by Moodys and S&P.

The Yield on a 5 Year T Bond is 1.92%.

It now costs more than one half of your return to guarantee a midrange US sovereign debt note.

Now if you take the next step, and view that return on a guaranteed US 5 Year Note as effectively .92%, you would have to believe that the rate of inflation will remain under one percent for the next five years in order for there to be any real return at all (Return on Guaranteed Interest Minus Inflation).

That is probably a 'flight to safety' phenomenon more than anything else, especially if one looks out on the yield curve to the 10+ durations.

That, my friends, represents an extremely dim view of the US economic situation, and a potential bubble in Treasuries.

Source: Markit

As an aside, as someone experienced in evaluating the financing of projects and companies, we wonder what figure companies are using as the basis for their 'riskless' rate of return calculations? Are they using 1.92% or 2.92% for a five year duration?

In other words, are US Treasuries still a risk free asset? Or are they risk free only with an unusually expensive Credit Default Swap? Expensive, that is, for the reserve currecy of the world.

Usually that detail is so small its lost in the noise, but with default risk now at about 50% of nominal return, that is a significant consideration.