Friday, January 8, 2010

Default risk on US Treasury Securities

If you get a test question asking about whether the US Treasury issues bills, notes, bonds, or STRIPS that present default risk to investors, how would you answer it? Apparently, it depends on how much Glenn Beck, Sean Hannity, and Rush Limbaugh you've been listening to. During the Friday Free Broadcast today, I tried to present a likely test question asking which investment risks an investor bears when buying a Treasury note. The answer--the one the exam wants you to pick--does not include "default risk." One of the attendees began to write that "just because they've never defaulted doesn't mean they can't default." Good point, but the answer is still: no default risk on a US Treasury Note.

Why? Because there IS no default risk on a US Treasury Note. About 220 years ago, the United States of America was formed, and one of the foundations of this new nation was that the federal government would assume all of the 13 states' debts that had been racked up during the 8-year revolutionary war that the legislatures never actually bothered to pay for. Alexander Hamilton insisted that the new central government had to show European trading partners that the credit of the new US Government was solid. After 220 years or so, without ever defaulting on its obligations, the US Treasury has earned the right to claim that their securities have no default risk. This isn't Russia, which in 1994 defaulted on its government bonds. This is a country that has paid its obligations for over two centuries. If you tell your clients that US Treasury securities aren't safe, that they are somehow subject to default risk, you could end up in arbitration or civil court when your clients avoid T-notes in order to buy your mutual funds, stocks, bonds, etc. In fact, if your client took your Glenn Beck-style anti-federal-government advice and avoided perfectly safe, secure Treasuries only to lose even 10% on what you recommended, his attorney would have a field day with you. He could say, "So, you're convinced that the US Treasury is not fiscally sound? Do you have any cash in your wallet? Could I see it for a second? Do you mind if I light this $300 on fire? Oh, you do? So, apparently, the US Treasury is strong enough to back up your money, just not your clients' money, is that right, sir?"
Maybe you saw that one coming and wisely left your currency at home. All the client's attorney has to do now is pull up a bunch of historical outcomes for mutual funds, stocks, and bonds. He would have ample examples of massive investment losses on bonds, stocks, and variable annuities. But for over 2 centuries, Uncle Sam has returned every dollar it ever borrowed from an investor. And you told the client that Uncle Sam was too risky; go ahead and buy this variable annuity instead.

This isn't just hypothetical. A customer who bought the Pass the 65 book has never been able to get registered because he went around showing senior citizens PowerPoint slides with titles such as, "Why your money isn't safe in the bank." I guess he also doesn't trust the US Government, even though its FDIC program has never failed bank customers. The regulators in Massachusetts decided it was a fradulent, misleading sales tactic--which it was. Just like the guy still up on NASAA's website who got caught on Dateline trying to scare people out of their bank accounts because "the FDIC's credit rating is F-minus."

Anyway, if you want to enjoy conspiratorial radio and TV ranters as a diversion, please do so. But be careful how much of that hysteria you bring to a test question and--more important--be very careful how much you bring to the table with your prospects and clients.

No comments:

Post a Comment