Government Bonds: No Longer a World Without Risk

José Viñals of IMF writes this superb post on the topic.

So far, most books and models treated govt bonds as risk-free. Not any more. Another major impact of this crisis has been that government bonds can no more be seen as risk-free.

One thing is now very clear: government bonds are no longer the risk-free assets they once were. This carries far reaching implications for policymakers, central bankers, debt managers, and how the demand and supply sides of government bond markets function.

After a recent IMF conference on a new approach to government risk, I’d like to highlight three key aspects:

  • In a world without a risk free rate, the health of the financial sector and the government are closely interconnected.
  • Countries with large potential liabilities from their banking sectors need to identify, assess, monitor, and report related risks closely.
  • The risks involved call for stronger emphasis on stress tests. 

He says all this has changed the demand and supply in bond markets:

  • Demand – Govt bonds are now seen as credit products where investors asses default risk and price them accordingly. They have become much like private sector credit products. Many are not liquid and there is not really a flight to safety. These bonds now trade as per trends seen in risky assets.

    Other problem is that of credit rating agencies and central banking collaterals. Most central banks take government bonds as collateral in refinancing operations. However lower ratings could imply these govt. bonds are no more risk-free and actually trigger sizeable haircuts like seen in other private sector bonds. This complicates many issues in central banking. Suddenly the most readily accepted collateral for central bank funds is no more readily acceptable. This would mostly imply the other collaterals are rated even lower. Which collaterals does a central bank accept now? You could actually be in a situation, where based on central bank guidelines, the central bank cannot accept any collateral and lend repo money!

    Though US Treasuries and German Bunds are still seen as risk-free, things have changed for many others.  

  • Supply – Debt managers in advanced economies are into a problem. They need to manage both – auctioning debt securities to manage the deficits and also look at risks of the bonds. Vinals says they have started behaving a bit like their emerging market colleagues. The adv eco debt managers are now following risk mitigation strategies, well beyond what traditional debt management objectives would indicate.

    IMF had looked at this issue earlier as well. There was agreement amidst some countries to follow Stockholm principles for managing public debt. There are 3 principles  –

The “Stockholm Principles” that emerged from this forum are organized around three main areas: framework and operations; the importance of sound market communication strategies; and the need for cautious portfolio risk management. “In tandem with efforts on the fiscal and monetary side, an unequivocal commitment to the practice of these principles could help foster confidence in public debt management, reassure investors, and ease market uncertainty,” Mr. Viñals stated. The “Stockholm Principles” have been drawn from a review of existing debt management practices used in a number of countries, debt capital market advisory services, and good practices outlined in other documents on debt management by the IMF, OECD, and the World Bank.

Vinals nicely sums it up as:

The global crisis is sending many of us back to the drawing board to take a fresh look at old assumptions and long cherished principles, and the risk free nature of government bonds is no exception

Earlier none of this was really thought. The supply of bonds was limited and there was hardly any risk. Now with both on the rise and most risks turning uncertain, the whole market mechanics of bond markets have changed and become more complex.

Am also wondering how would teaching finance change with all this. Most financial models (CPAM, valuation of equity etc) take risk free rates which are government bonds. Earlier finance would draw most values from government assets/bonds.  With the health of the financial sector and the government becoming closely interconnected, reverse seems to have happened. It is now that value of government assets/bonds also depend on the value/risk of financial system/assets.

Perhaps now finance economists/professors would also assume there is no risk of financial system/assets. Hence we can take govt bond yields as risk free rates!! Earlier this possibility was ignored completely and now becomes an assumption…

Fascinating stuff. So much thinking is required…


One Response to “Government Bonds: No Longer a World Without Risk”

  1. unsitko Says:

    There is a big difference in the risk of default of sovereign debt denominated in the currency of the sovereign debtor and sovereign debt denominated in a currency that the borrower can not be issued. This is the problem with the euro – Portugal can not issue euro. Therefore, it is entirely possible that Portugal will not be able to pay its debt in Euros. On the other hand, Japan, United Kingdom and the United States have all central banks, which can emit yen, pounds or dollars and buy public debt – for these sovereign default in their currency is extraordinarily unlikely. Another situation to distinguish who is a sovereign foreign currency debt of all – the Venezuelan debt denominated in U.S. dollars – here, again, there is a real risk that may not be able to come up with the dollars. I think this is an important distinction and I am frankly surprised to see a piece of the International Monetary Fund that do not report it.

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