Financial Storm's Last Port: Sovereign Bonds

Until you have spent it, money is always at risk. Once it is turned into a good meal or a night at the theatre or used to buy groceries or data bundles for your phone it is gone. As long as you hold onto it in whatever form it is at risk.

Physical cash in the form of notes and coins can be stolen and if left under the mattress for any length of time can become worth less due to inflation. Money in a bank account may be lost when the bank collapses or is misappropriated by the government. In order to preserve its value the concept of “investment” arose. Many “investments” simply help you to lose it even more quickly. The saying, “A fool and his money are soon parted”, remains true. Any time you buy a mutual fund or ETF or stock or bond you receive a transaction slip from your broker reminding you that these funds could disappear. Of course most people pay about as much attention to this as they do to warnings on cigarette boxes and alcoholic liquor containers.

So what really is the lowest risk area in which to have your money if calamity strikes? It’s really quite simple. Whatever could make you the most money is capable of causing you to lose the most money. So in a true crisis even bank accounts may not be safe. While the debt of corporations is generally more secure in crises than the stock, even the debt of the highest quality corporations can come under suspicion. In this situation it is only the debt of the most stable countries that affords genuine protection. Not only that, but it is the shortest dated debt that is the safest. The problem is that corporations can go bust taking their bonds and stock with them.

Countries do not disappear. They might have revolutions and change their names and split up into multiple other countries but they do not disappear so to some extent they may be more trustworthy. However very many countries have defaulted on their debt more than once. Defaulting is rather like infidelity, somewhat difficult the first time but it gets easier with practice. The US and Canada and a number of European countries (notably excluding Germany) have never defaulted on their debt.

However it is more complicated than that. In a true and complete financial panic where everything is suspect liquidity will become paramount. In that case even after interest rates have dramatically fallen, long dated bonds could see a spike in rates while 3-month treasury bills have negative yields. This is what happened after the 1929 stock market crash.

The legacy of Chinese debt default deserves a look. The Boxer and communist revolutions lead to changing regimes which defaulted on previous debt. The Lewisburg, Tennessee-based American Bondholder Foundation holds $1.6 trillion of century-old Chinese debt, including interest, dating to before the founding of the communist People’s Republic of China, that it wants the administration's help in redeeming. There is an estimated $6 trillion or more of the debt outstanding worldwide. Currently China and its State Owned Enterprises have trillions of dollars worth of debt, most of it in fact denominated in US dollars. Chinese domestic companies owe trillions more, also denominated in US dollars. Evergrande-the property development company is imperiled, and its ability to service its debts could soon become problematic.

Bankers are very strong people, they don’t fear viruses at all. They are like Superman and are impervious to almost everything. Remember that the only thing that bothered Superman was kryptonite, material from the planet from which he came. For bankers losing money is their kryptonite. Defaults are the major source of money loss, which can start a domino reaction throughout the financial system. Like a fire, if its small it can be contained but may rapidly get out of control.

Argentina has defaulted on its debt as have Zambia and Mozambique. Sri Lanka is perilously close. If the contagion spreads to counties like Turkey or parts of the Chinese financial system, panic will ensue. If Chinese SOE’s start defaulting China may have to sell her holdings of US Treasurys to plug some of the gaps. For those financial commentators (the majority) who cannot hold 2 thoughts together at the same time), this means that US Treasury bond prices will fall when exactly the opposite will happen as they are snapped up by a panicked financial system.

Simultaneously risk appetite will collapse and stocks, commodities, bonds and precious metals will sell off dramatically. If the crisis is not resolved quickly then Treasury bonds will sell off as well with a rush into short dated paper of the highest quality issuers. Record defaults would evaporate the world’s excess dollars sending the value of the dollar soaring. While this scenario has a small probability of occurring, if it does, it could wipe out your retirement prospects so it bears contemplating.