Many of us are concerned with minimizing investment risk. But what is safe? Finance textbooks normally say that the safest place to park your money is in U.S. government bonds. They don't pay much interest, but you certainly get your money back - at least that is what we used to believe. In August 2011, U.S. bonds were downgraded by Standard and Poor's, and they no longer carry S&P's highest AAA rating. A credit downgrade occurs when the rating agency determines there is an increase in the risk of default on the part of the borrower.
The credit downgrade and the burgeoning national debt create concern among investors that big-spending Uncle Sam might run out of cash, potentially resulting in default on government bonds. Due to the risk of non-payment, investors can now legitimately question whether buying a government bond is really that safe after all.
Even if the likelihood of an outright default is low, there is another threat of a different kind of default caused by inflation. The safety of investing in a government bond whose payoff is expressed in fixed units of fiat currency is risky in an environment where the government and central bank are reckless with stimulus spending and monetary expansion.
The U.S. government now routinely runs annual budget deficits in excess of $1 trillion, and finances the deficit by selling bonds. The Federal Reserve in turn buys $45 billion in government bonds each month, paid for with newly created fiat currency. This process is referred to as monetization of the debt, which means to a large extent the nation's spending is being financed by making new money.
The ultimate result of all the spending and money creation is inevitably inflation. With inflation, those savers who invested in government bonds are paid back in dollars whose value has depreciated. If bond investors are paid back with worthless dollars, the distinction between that and an outright default is one of semantics.
If you buy a 10-year government bond with an interest rate of 2 percent, it might seem like a safe investment. But if inflation over the 10-year period turns out to be 6 percent, then you have lost purchasing power at a rate of 4 percent per year; you have earned a negative real return.
One investment that eliminates the risk of inflation is a special kind of U.S. government bond called a Treasury Inflation Protected Security. TIPS are intended to be an attractive investment because they are indexed for inflation.
However, even with this type of government bond there is a problem: Currently TIPS with maturities of less than 10 years are paying negative real interest rates. According to statistics provided by the U.S. Treasury Department, as of Jan. 25, the annual interest rate on a five-year bond was minus 1.34 percent. A 10-year TIPS paid an annual interest rate of minus 0.56 percent. Locking in a guaranteed negative rate of return for five or 10 years - come on now, how safe is that?
The lesson is that risk is a fact of life in investing; there is no sure thing.
In an environment of gargantuan budget deficits and rapid money creation, a long-term investor should be wary when purchasing those U.S. government bonds that used to be regarded as the ultimate safe haven.