Could the U.S. government default on its bonds?

I’ve been asked many times over the years for advice on investing. “What is the market going to do?” “Should I be invested in stocks or bonds?” And, especially in the last few weeks, “Should I hold U.S. or foreign government bonds?”

Those are some good questions!  The answers are not as “good.”  The factors that drive the yields on treasury bills and bonds are complex and, despite Ben Bernanke’s pronouncements to the contrary, less well understood than stock returns, and I don’t have a crystal ball, but I can at least begin to frame an answer to these questions here.  I will come back to expand on this topic over time, as markets, economies, and world events evolve.

The return on both bonds and stocks is measured as the percent change between the market price today, and the cash flows received later.  The cash flows of a bond, namely coupon payments and principal, are specified in a contract; if they are not paid, the issuer is in default, and the bondholder has the right to take them to court.  The cash flows on stock, dividends and capital gains, are residual; they are discretionary, and are paid out only after debt payments and other obligations are paid.  For this reason, bonds are considered to be less risky than stocks, and the nominal yields on bonds are generally lower than those of stocks.   The risk-adjusted returns on stocks and bonds may be the same, but the nominal yields on bonds are typically lower.

There is an important distinction between the nature of the returns on bonds and stocks. With bonds, the future cash flows are known.  Movements in the bond’s yield are determined simultaneously with movements in the bond’s price. Once a bond is issued, only changes in interest rates (yield, risk) drive unexpected changes in its price.  Stock prices, on the other hand, fluctuate as either risk or residual cash flows change.  As a result, changes in a bond’s price, hypothetically at least, are a much cleaner indicator of the market’s expectations of future market rates of interest than a stock’s price.

One problem that distorts the information about expected future interest rates that is revealed by changes in the bond’s price is that bonds are less frequently traded than stocks, so the price data on bonds is less comprehensive and complete. In addition, the reported price data that form the basis of bond yield models often diverge from actual market-clearing prices, so that bond pricing models may not describe actual market behavior. Lastly, there is such a tremendous volume of economic and policy information, some of it conflicting, that is crammed into this one variable, the bond price which, given the coupon and principal, summarizes the market’s referendum on future interest rates.

by Sherry Jarrell

Next time: Sources and types of risk in U.S. and other bond prices.