Should You Fear U.S. Treasury Bonds?

I have received a number of emails from people, asking what I think of the United States reaching its debt ceiling —and the probability of the U.S. defaulting on its debt obligations on August 2nd.

The U.S. won’t default. Your U.S. bonds are safe.

You’re probably aware of the issue with Greece: Big debts and an uncertain ability to pay them.

With the United States it’s different: Big debts, but a certain ability to pay them—if they choose to.

It’s all political posturing, of course. Obama needs to raise the debt ceiling. If he can’t, then the U.S. risks defaulting.

The Republicans are using this opportunity to draw attention to (what they hope to portray) as an inept party in power.

Of course they’ll eventually raise the debt ceiling. To think otherwise is silly.

For some historical perspective, the United States raised its debt ceiling 17 times during Ronald Reagan’s presidency…8 times during the presidency of George w. Bush.

And the political posturing has occurred before. But our memories are short.

In 1987, Ronald Reagan said this:

“The choice is for the United States to default on its debts for the first time in our 200 year history, or to accept a bill that has been cluttered up. This is yet another example of Congress trying to force my hand…Unfortunately, [it] consistently brings the government to the edge of default before facing its responsibility.”

One person, via email, asked me whether she should momentarily pull her money out of the stock market to “see what happens.” Another person asked me about the safety o f buying Vanguard U.S. government bond indexes.

Most foreign governments see the U.S. silliness for what it is: political posturing with an agenda to make the current government look bad.

“The market is assigning a near-zero probability of an actual default happening,” said Thomas Simons, a money market economist at Jefferies & Co. “Until there is a significant event that makes Treasurys[sic] much more dangerous, foreign governments are going to continue to invest in the U.S.”

I don’t need to listen to Thomas Simons, the market economist at Jefferies & Co. to know that foreigners aren’t taking the debt default threat seriously. And I’ll show you how I know.

 

The chart above indicates how popular U.S. government bonds are. Bonds, like anything, are based on supply and demand. When demand increases, the prices rise. You can see that demand for U.S. government bonds is higher than it has been for many years.

If foreign markets were selling U.S. government bonds (and you can see that they were in 2006 and 2007) then the price of the bonds declines.

During the recent debt woes, the world’s largest holder of United States government bonds—China—has increased its holding of U.S. bonds by $7.3 billion since last May, to $1.16 trillion.

If you’re a bond holder looking at that chart and seeing some kind of bond bubble, with the increased popularity of U.S. bonds, let me show you the same plotted course from a different perspective:

The chart below is from exactly the same time period, but this time I compared Barclay’s 1-3 year Treasury bond index with the S&P 500 stock index:

 

The green line above is the movement of the S&P 500 stock index since 2003 and the blue line below it (the one that barely shows any movement at all) is the same 1-3 year Barclay’s global bond market index that I showed you on the first chart. The movement of the bond index on the first chart is simply exaggerated for a clearer sense of where the bond prices have gone. But when comparing the volatility of that bond index to the stock index above, you can see how stable the bond index really is.

Please note that the charts above do not include reinvested interest from the bond index, nor do they include reinvested dividends for the stock index.

The U.S. is certainly an interesting place when viewed from foreign eyes. Perhaps, from a global perspective, the U.S. could fix its debt issues far more easily than most Americans realize. The United States will raise its debt ceiling, and then it has to get busy reducing its debt.

Without the political posturing, it wouldn’t be that hard.

First, there’s the outrageous spending on wars that don’t appear to have any tangible benefit for anyone involved. By cutting back on war spending efforts, the U.S. can easily seal up a couple of the gaping holes in its fiscal bucket.

Second, there are the incredibly low taxes that Americans pay. And they’ll need to increase them.

Let’s start with gasoline prices. Countries, for instance, reap plenty of revenue from the taxes built into the prices of gas. An Australian friend of mine just came back from a trip to the U.S. last week, disgusted at the grumblings of folks he met at American gas pumps who complained about the “sky high” prices of gasoline. Most Americans don’t know what expensive gasoline prices are because they haven’t paid them….unless they’ve rented a car abroad.

Most countries, when they sell fuel at the gas pumps, tax that fuel considerably. But that doesn’t happen to the same degree in the United States. And it should—especially with the government’s current thirst for revenue required to ease the debt burden.

Keep in mind that the U.S. national pump price average, as of July 18, 2011, is a paltry $3.67 per gallon. You can see U.S. state and national averages GasBuddy.com.

According to CNN, here’s a sampling of world-wide pump prices.

By no means is the comparable CNN list above complete. It just gives a sample. After traveling to more than 27 countries myself, I have never found any first world country (not Canada, not New Zealand, not Australia, not Singapore) to have fuel prices anywhere near as cheap as they are in the United States.

When looking to fix financial problems, we have to fill the holes in our buckets (decreasing war spending efforts would work nicely for the U.S.) while slightly increasing the flow of water from the tap. With the U.S., some of this revenue could come from raising taxes on fuel prices.

And if Americans get upset at a further 20 percent or 30 percent future fuel hike, they can take a drive to the Canadian/U.S. border to see how many giddy Canadians are gleefully filling their summer motor homes at U.S. pumps—to pay some of the lowest fuel prices in the first world.

Then there are the low income taxes that Americans pay. It’s well known that average U.S. income taxes are far lower than they are for most of the developed world. International comparisons generally reveal that U.S. tax rates are kind to the rich, but not particularly lenient for the poor.

When George W Bush reduced the dividend tax rate, he granted a further benefit to America’s rich. But it’s worth noting that the middle class (as a group) spend much more money than the wealthy do. Increasing taxes for the rich (which I believe Obama wants to do) while lowering income tax levels for the poor and middle class, would keep money flowing into the economy, as the poor and middle class would have the ability to spend more.

In 2006, Warren Buffett stated (and has repeated it several time since) that he paid 15.5% tax on his income of $46 million while his secretary paid 30% tax on her $60,000 income. With a salary of just $100,000 U.S. a year, most of Buffett’s income came from dividends he reaps from the holdings in his private stock account. He also mentioned that a few of his friends calculated and compared their percentage of taxes with those of their lower level employees and the same conclusion was reached: the US tax system allows the rich to pay less than the poor.

In a June 2011 article for Personal Finance magazine, Asian tax expert Yong Siew Chuen notes that even the wealthy Chinese pay nearly double the income tax rates that wealthy Americans do.

This brings me back to the question that recently popped up on my blog, about the fear of investing in U.S. bonds. I think the U.S., despite reaching their debt ceiling, has plenty of wiggle room to play with. Like anyone suffering from debt, they need to reduce their expenditures that don’t make sense (wars) and selectively increase the flow of revenue (taxes) that can pay down the debt.

And for someone who’s still afraid of U.S. government bonds, there are U.S. corporate bond indexes that they could choose instead, such as the Vanguard intermediate corporate bond index:

Having said that, if the U.S. ever defaulted on its debt obligations, we would all be passengers on the Titanic anyway and the first to sink would be the country with the most skin in the game: China.

But the U.S. won’t default on its debt obligations, so don’t fear what the media or the political posturing drum up.

I have a healthy six figure sum in U.S. bonds. And I’m upset that the recent silliness hasn’t dropped their price.

If Fox News can do a better job of whipping up hysteria, I just might get what I want. Then I’ll buy U.S. government bonds with both hands.

 





Andrew Hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School (2nd Ed. Wiley 2017) and The Global Expatriate’s Guide To Investing: From Millionaire Teacher to Millionaire Expat (Wiley 2015). My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I’m happy to comment on your questions. However, please read the Terms of Use, Privacy Policy and the Comments Policy.

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27 Responses

  1. Brian says:

    Loved the post and enjoyed the picture. We're looking forward to reading your book!

  2. Andrew,

    Excellent article and well articulated thoughts. The U.S. is, of course, not going to default on its debt. I couldn't even imagine the thought crossing my mind. Like you, I'd love to see the prices drop as well, as I currently have no bond exposure.

    I agree with you completely on some of your ideas/solutions. I agree that the tax situation desperately needs to be fixed. Warren Buffett's comments are on point. It's really quite a shame that our tax system is so ludicrous. I personally wouldn't mind paying slightly more taxes if it gets our situation under control.

    I also agree on the gas tax. I especially agree from my point of view of living without a car. This kind of tax hike would be perfect, although a little selfish (personally).

    Great points and fantastic ideas. When are you leaving Singapore and coming to run for office? Just kidding!

    Take care.

    • Thanks Mantra!

      It's especially interesting how keen you are to hike the gas prices, considering that you don't have a car. I'm teasing you, of course, but there's something in it: a friend of mine here in Singapore thinks cars should cost twice what they do over here. They tax cars so significantly here, that anyone buying a new volkswagen would pay well over $100K. But he also has a point. Perhaps, those without an emotional attachment to something (a Singaporean resident without a car; a Dividend Mantra without a car; or an expat Canadian in a foreign country talking about the United States) have the potential to think more clearly!

  3. I'm fairly confident that the US won't default. There are several backup plans such as McConnell's purely political tactic of shifting the debt ceiling choice to Obama, or Obama utilizing the 14th amendment, and more likely, they'll just come to some poorly thought through agreement naturally. I do think there's a small chance that with a certain percentage of Congress coming from a rather extreme fiscal position born from desperation in the this rather severe recession, the US could potentially hit Aug 2 with no deal, in which case we'd probably keep paying interest and a subset of other expenses while most of the government shuts down until Congress got its act together and passed a debt ceiling increase.

    Dividend Monk's magical formula for fixing the US deficit!

    -Increase taxation, at least to Clinton-era levels. And make it more progressive. Remove the social security tax cap. Dividend and partnership taxes are so low. I give them permission to raise my dividend taxes :). The US has near its lowest tax burden in contemporary history, and significantly lower than taxes in most other developed countries. Plus among the widest gaps between the rich and everyone else.

    -Cut Defense spending moderately now, and then freeze Defense spending for five years. This would significantly reduce military spending as a percentage of GDP without doing so all in one large disruptive motion. Pass a law stating any time Congress declares war, they must institute a war tax to cover 100% of the expenses during the course of the war. (In addition to paying for it, we may think a little harder if it is going to immediately hurt our wallets.)

    -Split taxes into portions and never allow borrowing to occur between portions. This is already somewhat done in theory, but not in reality. So, have a "federal tax" for all the miscellaneous government department spending, then a "health tax" for medicare, medicaid, and related programs, and a "social security tax" for the rest of the OASDI benefits and lastly, a "Defense tax" so people can see how much they are spending on military each year. Plus, sometimes there would be the aforementioned "war tax". Each tax should be balanced such that there is a slight surplus, and any debates would be more focused on how to balance that particular segment, so we can stop having distracting arguments about the whole pie. If politicians say they want to cut spending, let them specifically say they want to cut the OASDI tax and spending, or the Medicare tax and spending, and see how well that goes over.

    -Get our clean energy situation together already. Allow clean energy infrastructure such as wind turbines, solar, hydro, and other sources to be included in Master Limited Partnerships. That alone should boost this market by tens of billions in market capitalization rather rapidly, and eventually, hundreds of billions. Then, tax gasoline and use the proceeds to provide very attractive loans to these businesses that operate clean energy, so that their leverage increases their profitability by a few points more than it otherwise would be, and use the rest of the gas proceeds to fund research into algae biofuels or whatever else is considered most promising. Set the goal to be energy independent.

    Or we could just keep reducing taxes and keep spending more. How's the weather in Singapore?

    • Hey Dividend Monk:

      My wife is American, and after reading your comment, she said that it was the first time she had seen anyone mention a war tax that would cover 100% of a war's costs. She thought that was a briliant solution–suggesting that the government would have to have its people on their side if they were going to fight again. No citizen would have a problem paying for a war that was justified: like a defense against a foreign invader beating the tar out of Pearl Harbor, for instance–and threatening to do the same elsewhere on American soil. The people would gladly chip in, she figures. Heck, during the Battle of Britain, people were giving up their pots and pans for recycling, so the RAF could have Spitfires and Hurricanes built–such was the desperate need for steel. Now that was a country that desperately needed to fight, and pay for a war in whatever way they could. If the U.S. people got hammered in the pocketbook, as you suggest, they would think twice about the validity of a war, and would likely storm the Whitehouse if it was a silly idea, in their view.

  4. MoneyCone says:

    "If Fox News can do a better job of whipping up hysteria, I just might get what I want. Then I’ll buy U.S. government bonds with both hands."

    Nicely put!

    • Hey MoneyCone,

      I sure hope I don't offend any of my U.S. based friends with this story:

      My wife and I were in Pennsylvania a few years ago, and we visited some friends of her moms. They were really nice people–and educated.

      And they turned on the TV and started watching Fox News. Well….it was the first time I had ever seen it. From purely virgin eyes, it looked like a cross between the National Enquirer, Entertainment Tonight, and BBC News. I wasn't sure what to think, but I made some crack about it. And it didn't go over too well. For these folks, this was their favorite news program, and I think I offended them when I laughed at it. I can't even remember what they were discussing on the news, but it seemed so strangely sensationalized, whatever it was. I became fascinated by it. And surprised by it. I started to watch it regularly when I was in the U.S. And it was the first time I had ever seen an entire news program with a political agenda…a very clear political agenda…and one that blended itself so oddly with an Entertainment Tonight concept. I asked my wife, "do many people take this show seriously?" Her answer disturbed me. Again…I hope I didn't offend anyone with this. This is just my take, viewed from the eyes of a foreigner. Who's to say I know much of anything anyway?

  5. It's all about posturing….political jockeying really. I have the upper hand on you, no, I have the upper hand on you. Too bad politics is just that – a power struggle. So much time is wasted on one-up-manship and it's so very unnecessary when it comes to running a business, a multi-trillion dollar business like the U.S. economy.

    Alas, things will never change with government in my lifetime I'm afraid (I'm 37), not here in Canada nor the U.S.

    Like Monk, I’m fairly confident the U.S. won’t default. All in all, don't worry about U.S. debt folks. While it's not going anywhere, anytime soon, it is not going to default on their debt – the country would be ruined if that happens.

    Sadly, the approach will need to be two-pronged for at least a decade: increase taxes by 3% for the middle-class and 6% for the upper-class, for at least the next two years, and cut government spending across the board by at least 5% in every department. Defense and space exploration departments take a larger hit, at least 10% cuts immediately.

    Just like a budget at home, you shouldn't spend what you don't make.

    • Hey Mark,

      You have some good ideas. Perhaps they should increase the taxes paid by the wealthy by 6%. And perhaps they could increase the lower tax brackets by 3%. But I'm wondering whether just increasing fuel prices would tax the middle class/lower class enough. Heck, the government could get a heck of a lot of revenue if it increased gas prices by 20%. And U.S. gas would still be a lot cheaper than it is in Canada, Australia and other first world countries. I mention Canada and Australia specifically, because they are also countries where many people have to drive long distances.

      When I'm at American fuel pumps, I'm almost giddy at the cheap prices I pay. A few years ago, we were paying close to $4 a gallon at a U.S. pump (it has since dropped and risen again) and I ignorantly (and loudly) said to my wife, "I can't believe how cheap the gas is here!" I sure got a few unfriendly stares for that.

  6. Oh yes, I forgot to mention Andrew….and readers….Canada is noticeably absent from your list of gas prices.

    Don't forget we're pricy as well! I just filled up my 2000 Mazda Protege yesterday for $1.30/Litre here in Ottawa. It cost me $51.00 for the tank that was near empty.

    For those that would like the conversion, that's close to $5.00 per U.S. gallon. That makes U.S. gas under $4 per gallon, on the world stage, a pretty darn good deal.

    Milk costs more for the same quantity 🙂

  7. To Andrew's credit, he didn't leave Canada out entirely.

    "And if Americans get upset at a further 20 percent or 30 percent future fuel hike, they can take a drive to the Canadian/U.S. border to see how many giddy Canadians are gleefully filling their summer motor homes at U.S. pumps—to pay some of the lowest fuel prices in the first world."

  8. @Dividend Monk – true enough. Heck, if I lived closer to the border, I'd do just that this weekend!!!! 🙂

  9. I should probably clarify that my wife has U.S. bonds in her Vanguard account.

  10. Pat says:

    Excellent post and replies. I couldn't stop reading it. From what you have shown here, I have to agree that they hopefully won't be foolish enough to allow a default to happen. But my question is this, just suppose that they did go into default. Would held savings bonds and treasury investments then become permanently worthless? (that is what I have read online several times), or would they just temporarily be not redeemable or earning any interest until if and when the government met it's debt obligations and had gotten things straightened out?

    • Hey Pat,

      I really don't know what would happen. I can guess, of course.

      People would sell, and the value would drop, but there would likely be a speculative market (actually, it wouldn't be so speculative) that decided to buy U.S. bonds at the plummeting level. I would likely be one of those people.

      The U.S. would free up their money eventually, and the defaults would stop. Then the prices would rise once more.

      But I feel a bit silly writing that because I really don't think it's going to happen. The U.S. can afford to make those payments. At the 12th hour, the political posturing will come to a dramatic resolution. Political pride is making this dramatic. But it will be pride that ensures the raise in the debt ceiling as well. The U.S. would be a world laughingstock if they defaulted on their loans….because they can actually afford to pay them. American politicians are too smart AND too proud to let that happen.

  11. At these prices you won't catch me buying US Government bonds. The potential returns just don't justify the risks. The US Government will not default on its bonds, despite all the fear mongering on the left. What is more likely to happen is a downgrade resulting from the spending binge the government has been on the past 10 years. 1, 2 or 3 percent yield depending on maturity is not enough of a margin of safety when interest rates inevitably start to rise in the US. I guess it is possible that the US could be the next Japan, but in either scenario US Government bonds aren't a very appealing investment.

  12. Hey Biz,

    It's going to be amusing when they dramatically come to the 12th hour resolution, don't you think?

    You're right about the yields being low. For me, I don't think as much about their yield as I think about their relative stability, compared to stocks, over the long haul—and the fact that they allow me to be greedy when others are fearful when stock markets fall.

    • Andrew,

      The deal will get done sometime in the next two weeks. It may not be signed by 8/2, but the politicians on both sides will cave into the pressure. When you look at the growth rate of US Government debt, the entire concept of a debt ceiling should just be done away with. It just creates these artificial crises that make the politicians seem more powerful.

      I've thought for a while the 40 year bull market in the bonds is coming to and end. Hard to see how rates can go much lower unless the economy weakens further. That being said, I have been buying short and intermediate term corporate bonds, GNMAs and high quality munis. And, as always, using the fear-trade to pick up more equities.

      • Hey Biz,

        You're right! Using fear can be an amazing strategy if you can isolate yourself from it. Most of the fear, related to the markets, is (and always has been) irrational. And most of the euphoric greed has been equally crazy. Follow that middle road, and be greedy when others are fearful, while being fearful when others are greedy and it will serve you really well if you're diversified, and not just chasing some junk bond or individual stock into the gutter! But you know that already–and better yet, your practice it!

  13. Pat says:

    I am wondering also though about I-Bonds, (US Savings Bonds)which many people hold for a retirement supplemental income. Those are savings bonds that are guaranteed to pay a rate adjusted quarterly to inflation. So wondering what the result would be for those if there were a default on Aug 2.

  14. The deal will absolutely get signed.

    The lead up to this "deal" is all about political posturing, that plays on the minds of skeptics, forecasters, prophets and traders of the market.

    Just my opinion of course, I've been wrong before 🙂

  15. Pat says:

    I asked that question directly to the Treasury Dept. and just received a response which is right in line with yours, thanks for your ideas Andrew. Here is what they responded;

    1.Treasury fully expects congress to raise the debt ceiling before August 2

    2. Treasury operations are proceeding as normal

    3. And, we can't speculate on what will happen on or after August 2

    4. Please refer to Treasury's website for further information and Secretary Geithner's official statements
    http://www.treasury.gov/initiatives/Pages/debtlim

    Thank you.

    Barbara

    Customer Service Specialist

  16. Hey Andrew,

    Thought you might like this article, based on your post 🙂

    http://www.theglobeandmail.com/globe-investor/mar

  17. chris says:

    This article was a very interesting and informative read! I am an American, anf I agree whole heartedly with your views! Unfortunately, I am not a Blogger, so I have no way of knowing when you make new posts. If you have a newsletter, please sign me up! Also, when your book comes out, I DEFINITELY want to know where I can purchase a copy! Please email me this information on where to purchase. Once again, this was an amazing read! God bless!

  18. Pete says:

    According to Zero Hedge, countries outside of the U.S. dumped 74 billion dollars in U.S. Treasuries, most of it over the weekend:

    "Over the weekend, we observed the perplexing sell off of $56 billion in US Treasurys courtesy of weekly disclosure in the Fed's custodial account (source: H.4.1) and speculated if this may be due to an asset rotation, under duress or otherwise, out of bonds and into stocks, to prevent the collapse of the global ponzi (because when the BRICs tell the IMF to boost its bailout capacity you know it is global). We also proposed a far simpler theory: "the dreaded D-day in which foreign official and private investors finally start offloading their $2.7 trillion in Treasurys with impunity (although not with the element of surprise – China has made it abundantly clear it will sell its Treasury holdings, the only question is when), has finally arrived." In hindsight the Occam's Razor should have been applied. Little did we know 5 short days ago just how violent the reaction by China would be (both post and pre-facto) to the Senate decision to propose a law for all out trade warfare with China. Now we know – in the week ended October 12, a further $17.7 billion was "removed" from the Fed's custodial Treasury account, meaning that someone, somewhere is very displeased with US paper, and, far more importantly, what it represents, and wants to make their displeasure heard loud and clear. (Source)

    Undoubtedly, the Chinese and other countries have recently discovered that Italy and Greece, with smaller debt to income ratios than the United States, are less riskier and carry a higher rate of return. This is because, unlike the US, the Rothschild/Rockefeller bond rating agencies have trashed their country's debt ratings, forcing them to pay a much higher interest rate than U.S. Treasuries. Hey, if you take the risk, you might as well earn the reward!

  19. Hi Chris,

    I'm sorry to have missed your comment and question on my blog. And many thanks for the kind words about my site.

    My book is available on Amazon at the following link: http://amzn.to/millionaireteacher

    I think you'll like it!

    Cheers,

    Andrew

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