Move Over, Treasuries. These Are the New Safe Assets.

An anti-austerity demonstration in Paris on Sept. 18. (Nathan Laine/Bloomberg)

Key Points

About This Summary

• Mounting debt and deficits are causing skepticism about sovereign governments’ creditworthiness.
• Some French corporate bonds are yielding less than French government bonds, reflecting concerns about France’s deficit.
• BCA Research suggests investment-grade corporates are now the risk-free interest rate, due to surging government debt.

Whom would you rather lend money to? Somebody perpetually losing money and deep in hock? Or someone who is consistently profitable and has a substantial net worth?

One would presumably have a lot more confidence in getting repaid by the latter than the former. But in financial markets, the opposite remains the prevailing assumption when governments are the debtors. Sovereign debt is presumed to be free from risk, given the government’s power to tax and, at a last resort, to print the currency in which the debt is denominated.

That makes government obligations the risk-free baseline against which all other securities are valued. The riskier the corporate credit, the greater the yield margin—or “spread”—they provide over the comparable government issue.

The market, however, is beginning to express skepticism on this long-held presumption. Mounting debt and deficits have called into question sovereign governments’ creditworthiness, with the U.S. government losing its last top triple-A rating from Moody’s earlier this year.

Elsewhere, French government bonds (known by the acronym OATs) have been trading at higher yields than some corporate debt, BNP Paribas analysts wrote in a client note this past week. Fitch Ratings downgraded France’s rating to A+ from AA- on Sept. 12, following the government’s defeat in a no-confidence vote, which it said makes it unlikely the budget deficit can be brought down to the government’s target of 3% of gross domestic product by 2029. The bank said some 7% of French corporates traded at lower yield than comparable OATs, a reflection of domestic protests over efforts to trim the deficit from 5.4% of GDP, one of the highest in the euro zone.

Even with the U.S. deficit running at 6% of GDP, corporate debt still yields more than Treasuries, although the spreads have shrunk to historically tight levels. (A rare exception: A Microsoft note due November 2035 with a 4.2% coupon was offered this past week at a yield of 3.625%, below the 4.11% of the benchmark 10-year Treasury at the time. Then again, Mister Softee boasts triple-A ratings from the major credit-rating firms, two notches better than Uncle Sam.)

Given the soaring debt of governments around the world, BCA Research provocatively asserts that investment-grade corporates are now the risk-free interest rate.

“Surging inflation, aggressive central bank tightening, and the end of the zero-lower-bound and negative-rate era have turned the world’s benchmark asset class into a source of volatility and pain for investors,” BCA strategists Jeremie Peloso and Robert Timper wrote in a research report this past week. “What used to be the anchor of portfolios has instead become a roller coaster.”

Government debt has burgeoned since the 2008-09 financial crisis, while corporate debt has been stable and even declined in recent years. “The level of debt only tells one side of the story,” the BCA strategists wrote. “The worrisome part is that the U.S. government’s net interest payments as a share of GDP have surged, starkly contrasting with nonfinancial corporates’ manageable debt-service ratios. The latest One Big Beautiful Bill Act does not alleviate the picture.”

In particular, companies took advantage of record-low bond yields in 2020 and 2021, much as U.S. homeowners locked in sub-3% mortgage rates. At the same time, the increase in private credit markets has shifted some corporate borrowing from the public markets.

One of the less-noticed aspects of the massive expansion of U.S. government debt is its impact on market benchmarks such as the Bloomberg U.S. Aggregate Bond Index. Treasuries’ share of the Agg, as it’s known, has more than doubled to over 50%, from 21% in 2007, before the financial crisis.

The Agg is analogous to the S&P 500 for equities. Treasuries’ weighting in the Agg also appears similar to the impact of the Magnificent Seven stocks for the S&P 500. But where the likes of Nvidia and Microsoft have come to dominate the U.S. stock market because of their huge profits and growth prospects, Treasuries have become dominant in the bond market owing to Washington’s profligacy.

All this argues for a re-examination of one of the basic tenets of Finance 101—that government securities should form the baseline for risk-free returns. And it further calls into question whether fixed-income investors should slavishly follow the Agg as their benchmark.

Recent returns from popular exchange-traded funds tracking different sectors are revealing. The Vanguard Total Bond Market ETF, which tracks the Agg, returned 2.58% for the 12 months through Sept. 17, and 4.15% over the latest three years, according to Morningstar. The iShares U.S. Treasury Bond ETF, which has a similar duration (a measure of interest-rate sensitivity) to the Agg, returned 1.59% and 2.98% over those respective spans.

Meanwhile, the iShares iBoxx $ Investment Grade Corporate Bond ETF returned 3.02% in the past 12 months and 5.94% over the past three years. (This ETF has a slightly longer duration, which has been a negative over those spans.)

To be sure, this has been a period of economic expansion, with rising corporate profits. A recession would likely see corporate bonds underperform for a spell.

But the assumption that government debt is riskless is questionable. If not via outright default (as in the case of repeat offenders over the past two centuries, such as Greece and Argentina), sovereigns historically have managed to reduce their real obligations via inflation. The irony is their ability to use the monetary printing press to pay their debts is also what makes their bonds riskless.

That seems to be the modern version of coin clipping—shaving slivers off gold or silver coins to mint more of them, the ancient ploy of debt-laden regimes. Maybe this history is why central banks have been avid buyers of gold, helping push the supposedly barbarous relic to record highs.

Write to Randall W. Forsyth at randall.forsyth@barrons.com