Will some of the buyers of Treasurys come to regret their decisions?
The bonds of the United States are often-described as risk-free. This is largely true because if you hold them to maturity, you certainly won’t lose money. Even if a temporary hiccup such as a debt ceiling results in a missed coupon payment, you’ll almost certainly get repaid every dollar you are owed.
The principal reason for this security is that the U.S. issues debt denominated in its own currency. It never has to default on this debt because it has unlimited amounts of the currency used to repay it. Unlike Italy, which must either borrow or tax additional euros in order to pay its debt, the U.S. never has to worry about coming up short of dollars.
But this doesn’t mean that buying U.S. bonds is a risk-free strategy for everyone. In particular, U.S. debt is priced extremely high right now — with yields being extremely low. If the price of the debt falls in the future, you will find yourself running the risk of being forced to hold the bonds until maturity or a price recovery. Or you’ll take a loss on a sale.
Over at the Free Exchange blog at The Economist, Allison Schraeger points out that bond prices will most likely fall — and some investors will be forced to take losses.
Bond yields only reflect the nominal return if you hold the security to maturity. Otherwise, yields and returns are two different things. Many investors do not hold their bonds to maturity: pension funds, bond funds, and insurance companies who must maintain a particular duration; any institution that suddenly needs to sell their long-term bonds when they need more liquid short-term assets; or anyone who’s trying to dump their Italian bonds now. When you sell a bond before it matures your return is the change in price from when you bought it. Prices can be quite volatile, especially for bonds with longer maturities. German and American prices are also quite expensive compared to their historical average. Unlike equity prices, bond yields mean revert over time, meaning they rise and fall around their historical average. This suggests the price of German and American debt is due to fall someday. Yet investors seem quite keen to buy it up at historically high prices, all to avoid risk.
To put it differently, if interest rates return to anything like normal — which they almost certainly will someday — the prices of bonds paying ultra-low coupons will fall. People would rather hold bonds issued by the same government that pay higher interest rates. If you have to sell before maturity, the idea of buying ultra-low rate bonds won’t feel risk-free at all.
Of course, bond rates could stay low for a very, very long time. The Federal Reserve is already promising to keep rates low until sometime in 2013. And, as the example of Japan shows, rates can stay low for even longer than that.
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