The financial media has regularly referred to US Treasuries (US government bonds) as risk-free investments on the basis that the US government fully backs to pay the coupon and principal payments on its debt instruments. And historically, we know, they have a strong and consistent track record of making said debt payments.
Additionally, it is frequently suggested that the government has power to raise taxes on its entire population of consumers and businesses to raise sufficient funds to meet its interest and principal payment obligations. This does imply US Treasuries are a relatively lower risk asset but I think it’s important to clarify this viewpoint implicitly assumes an investor holds such bonds to maturity.
You might, however, be scratching your head in frustration and, appropriately so, when you look at the reality that US Treasuries have underperformed US equities so far in 2022. How could a supposedly risk-free government bond underperform a higher risk equity investment? It comes back to what happens when you relax theoretical assumptions and, reflect back upon the past decade of ultra-low interest rates and negligible inflationary pressures. Events conditioned financial markets, investors, companies, individuals and governments into expecting the ‘modus operandi’ to endure. Yet, the COVID-19 pandemic tore up the past decade’s operating manual and stress tested somewhat fragile and transient assumptions.
So, the price of US Treasuries has fallen through 2022 to reflect mark-to-market price drops that emanate from two key risk factors inherent in nominal US government bonds: interest rate risk (known as duration risk) that seeks to reflect the negative price hit a bond faces from rising rates and; inflation risk which reflects the negative price hit a nominal government bond faces when its fixed coupon becomes uncompetitive relative to other investments after you factor in the real value erosion of inflation.
How could a supposedly risk-free government bond underperform a higher risk equity investment?
Today’s prevailing environment appears to be: high levels of headline inflation and, a central bank reaction that seeks to hike short term interest rates aggressively to slowdown the global economy. This is a plea to compress aggregate demand downwards towards aggregate supply and quell inflationary pressures. Should we therefore investigate the potential of floating rate notes?
Floating rate notes (FRNs) are short dated fixed income instruments but unlike nominal government bonds with fixed coupons, FRNs tend to pay out variable coupons which adjust upward or downward based upon a variable benchmark interest rate. Floating rate notes can be issued by governments or corporates and tend to have low maturities i.e. two to five year terms. In today’s high inflation and rate hiking environment they might just help investors mitigate interest rate and inflation rate risk.
Though, a word of caution, the market for floating rate notes is considerably smaller than that of nominal government bonds. Investors should carefully consider liquidity risks and potential crowding risks when seeking out less liquid investment opportunities.
Illustration by Isabelle Bamberg