US Treasury investors must confront downgrade risk

Illustration: Chen Xia/GT

Swelling US deficit could compromise safe haven

The yield on 30-year US Treasury securities fell to 2.76 percent Friday, the lowest point since the fourth quarter of 2012. Meanwhile, 10-year Treasuries bottomed out at 2.09 percent on the same day during a slump that left the benchmark note with its steepest weekly decline in more than two years.

With Treasury prices also on the rise, what we're seeing now in the government debt market is likely a rush to safety as declining oil prices pummel equities and other assets. With many expecting the rout to continue, markets around the world have been rocked over recent days by sell-offs. To mention just one of the latest confidence-shattering forecasts, the International Energy Agency lowered its expectation for global daily incremental crude demand to 900,000 barrels per day Friday, down from 1.13 million barrels previously.

As investors shift into bonds, US Treasuries have remained broadly attractive relative to other sovereign debt products. For example, despite persistent concerns about economic malaise in Europe, yields on German and British 10-year bonds were as low as 0.63 percent and 1.81 percent by the end of last week.

The market for Treasuries has expanded rapidly over the past few years with the US economy's recovery from the global financial crisis. Recent statistics from the White House put Treasury debt at $12.9 trillion by the end of November, 2014. This compares with $6.3 trillion by the end of 2009.

Looking ahead, the US government's aggregate liability is set to hit $26 trillion in 10 years' time based on a current debt growth increment of about $3.5 billion per day, according to media estimates. Based on such calculations, US Federal debt could account for 180 percent of GDP by 2035.

The market's continued confidence in Treasures is surely a boon for the country as it works to maintain its fiscal expenditures. But as investors batten down the hatches against mounting volatility in the global capital market, are US treasuries such a safe bet? Perhaps not.

Over the past two decades, the US federal government has had a budget surplus for only three years: between 1998 and 2001. This year alone, the federal government is expected to take a deficit of $492 billion, according to estimates from the US Congressional Budget Office. Federal authorities will have to continue issuing more Treasury securities to pay off older debts and support government spending.

If the US continues its current pace of debt expansion, its credit rating could suffer a costly downgrade. Indeed, to maintain a rating above AAA, the country's debt-to-GDP ratio should not exceed 110 percent, according to standards set by the world's top ratings agencies. Based on recent trends, it seems that this ratio will only rise over the near-term. In fact, earlier this year Standard and Poor's reiterated its AA+ rating on US government debt, saying that it sees less than a one-in-three chance of changing this rating over the next two years. The agency stripped the US government of its highest rating in 2011, citing political feuding over the country's debt ceiling and lack of plans to pare down a widening deficit.

As with any form of debt, investors are exposing themselves to a certain degree of risk as they snap up US bonds and notes. If Treasury securities are downgraded, this could introduce a new level of turbulence into the global market, leaving the foreign investors who already hold some $6.06 trillion in US debt vulnerable to hefty losses. But with few safer assets to choose from, that is a risk that many investors seem willing to take.