You Can't Argue With the King

Government bonds: safe haven or risky loan to a capricious tyrant?

What's the safest investment in the world of bonds? Government bonds, as every dewy-eyed novice with a portfolio can tell you. Second in line are bonds issued by stable companies, only after which we find high-yielding bonds, known in market parlance as junk bonds.

This order of things is deeply ingrained in investors' consciousness and being. The fact is that the yields on corporate bonds are often presented in terms of their surplus return over comparable government bonds. "Risk-free interest" in economic models is actually the rate of interest on the appropriate government bond.

Queen Elizabeth II

But is it really so?

When buying a bond issued by a company (thereby lending money to that company ), the buyer can demand securities to assure repayment and can demand guarantors as well. Moreover, bondholders are represented by a trustee, and the law requires companies issuing bonds to list the risks to the investment in the prospectus.

Making any misrepresentation about the investment is illegal, and in most of the West, issuers making false statements risk jail. In some bonds, the debt is protected by covenants requiring the issuer to maintain certain minimum equity or cash levels.

At the very least, the borrower is expected to take steps to safeguard his good name in the marketplace. That involves avoiding default. But if the company goes south, there is an orderly procedure for liquidating and distributing assets among creditors, including the bondholders.

Exempt from the slammer

What of all that does the buyer of a government bond get? Nothing. No collateral, no courts, no guarantors, no covenants, no fine if repayment tarries, no jail for misrepresenting facts. There is no personal good name to safeguard. The only thing on which investors in government bonds can rely is the faith that the government in question will want to repay them in full - and the stress is on the word "want."

The thing is, the government doesn't always want to. Greece is poised to default on its bonds. Anybody invested in Greek bonds has already lost a great deal of money, on paper at least (assuming the investor didn't sell the bonds and lock in the loss ) because the market value of Greek bonds has tumbled. That loss may soon become an inescapable fact, just like the fact that Greece lied in its presentations to investors and at the end of the day will repay them what it decides to.

It's not rare for a nation to go bankrupt. That's how it's been for centuries. It has been considered riskier to lend to a nation than to a rich man or company, or sensible business venture. The state is king. It is above the law. It will repay when and how much it wants. If it doesn't want, or resorts to ploys such as weakening the currency in which the loan is denominated, there's nothing the lender can do about it. One doesn't argue with the king, and kings have shown much scorn for debt over the millennia.

Actually, the image of government bonds as a risk-free investment is a new thing, going back a few decades, and even in that time, plenty of countries have defaulted. Recent examples include Ecuador in 2008, Uruguay in 2003, Argentina in 2001, Ukraine in 2000, Pakistan in 1999 and Russia in 1998.

Greece received independence in 1831 and has gone bankrupt five times since then. Spain, which could well default, has turned its back on its debt 13 times since 1476. The king simply didn't repay.

So whence that blind faith that countries will meet their financial obligations?

One main argument supporting faith is that a country won't stiff bondholders because otherwise it won't be able to borrow from them again in the future. The other main argument is that a country can always tax its people more to repay debt.

In the 1970s, Walter Wriston, CEO of Citibank, famously said, "Countries don't go bust" and promptly lent enormous sums to a number of countries, some led by highly dubious dictators. Wriston thought it would pay. Instead of working hard to judge the merits of thousands and thousands of loans to businesses, the bank extended a small number of gargantuan loans to nations at high interest. But some of the countries didn't repay.

Regulators are also responsible for the squeaky clean image of government bonds. The international Basel agreements say banks don't have to tie down capital to secure investment in government bonds with high credit ratings. The banks thought it was a sweet deal: They get returns and don't have to tie up their money. But now here they are, stuffed to the gills with government bonds whose value has tanked, and very unlikely to get their money back in full.

Also, beyond a certain point, imposing more tax actually diminishes tax revenues. Everything's political, anyway. A given government can decide it isn't ethical to gouge its citizens today in order to finance past spending, or it may decide not to honor the liabilities of a previous leader or government.

In rich countries, under normal conditions, government bonds are a safer investment than loans to a company. But things can change fast. The people of Greece, Iceland, Ireland and other countries simply cannot accept that they have to foot the bill for past profligacy and adventurism by financiers acting in the name of the state.

At the end of the day, the risk in a government bond is a function of the national consensus, not collateral, economic analyses or the national mint. You stand warned.