Flight to Quality

Every time I hear that bond investors are flocking to quality, and that quality = lending to the U.S. government, I think the following:

  • what’s so high quality about U.S. government debt?
  • is this really just because business schools use Treasury’s as the canonical example of a “risk-free” asset?
  • what’s a “good” debt-to-income ratio for a government, anyway?

The U.S. economy is big

The U.S. produces roughly $10 trillion worth of goods and services per year, and its government can tax that — to a degree. But other countries also can tax their citizens. And if you added together some smaller countries you could find another $10 trillion of taxable income. (Governments can tax old assets too, like real estate.)

If you’re not a giant fund looking to plunk all your money in one place, you could lend money to 5000 municipalities or cities or something, and is California really any more interested in defaulting than the U.S.? And California is like the world’s 4th largest economy, if you broke it off from the rest of the States. Not only that, but “diversification” is the buzzword for panacea in finance.

“I’ll believe in whatever they believe in”

I get that, like, people think the US Government won’t default on its debt. Partially that’s due to a feedback loop—so many people believe it to be the case that the government can cheaply borrow to cheaply pay back the current debts with cheap future money. After the “financial meltdown” people and institutions from all over the world were shoveling so much money into the Treasury’s coffers that the government would have been stupid to turn them away. This when Uncle Sam was spending, what, $2 trillion on the bailout?

But a feedback loop the other way — a sudden loss of trust — could cause Uncle Sam’s lenders to jack up the API on his credit card, and each dollar of interest might spike to $1.05, $1.15, $1.25, who knows. The laws of calculus would no longer apply, i.e., small changes might become huge jumps and suddenly the default looks a lot more attractive — thus raising the interest due even more.

_Why?

Really, I don’t get it. I have never invested in a bond in my life. I have never analyzed a municipality’s balance sheet, a county’s, a state’s, or a country’s. I’m not even sure if I should be writing Treasuries, Treasurys, or Treasury’s. But still I wonder, why do people consider an investment in U.S. Treasurys to be risk-free?

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