NP: No gov't; best gov't..from John Lanchester LRoB

[alice wellintown]

Paul is, again, right; we can't sum this up in a few posts.

The major investors in UST have limits set and are restricted in how
and where they may invest. For example, the pension for the state of
California has restrictions by law. It must invest a percentage, for
argument sake, say 85% of its monies in AAA rated securities.
Traditional institutional investors, like the manager of the State
pension funds, buy UST securities. First, they can't buy enough IBM or
other corporate bonds that have a AAA rating because the AAA rated
corportate bond market is neither large enough nor liquid enough to
meet the investment criteria. Second, because traditional managers,
large institutional investors,  run what is called a match-book, that
is, they match liabilities with assets, and because pension
liabilities are based on complex formulas that calculate the life of
the employees (the standard mortuary of actuaries at life insurance
companies plus retirement ...), and because the best match is long
term (non callable--most UST are non callable, unlike long corporate
bonds that usually have a 5 year call) UST. Now, without getting into
average life and AAA rated mortgages (we would need to call in Fabozi
to explain this), we can see that the credit rating of securities is
not a trivial matter and that the news, the press on this, the spin
actually, is absolutely wrong and misleading. Ratings from S&P are
essential to the capital markets. Because every security is traded at
some premium, a higher yield and thus a higher cost to the borrower
over UST, the benchmark, and because other debts, like home mortgages,
are traded off UST, the UST is and remains the benchmark, the base,
the curve for all other debt traded. Now, the credit rating, AAA, AA,
A etc., is only one risk. It's called the credit risk. Will the
borrower pay the interest and principal as agreed to in the bond
agreement? Again, corporations, because they can merge, sometimes can
be forced to merge, or are taken over, sometimes with LBO or leveraged
buy outs, and because this often reduces the quality of the debt, are
by nature a greater risk than UST. This is why in the Milken days of
LBO, poison pill provisions were demanded by institutional investors.
These pills did not always work and the courts did not give the
investors a fair shake so more reason to avoid AAA corporates and buy
UST. But, credit risk is not the only risk. If the UST has no credit
risk, and it has almost none even at AA+, in part because it doesn't
have to pay its bills as households do, it still has market risk and
inflation/dollar risk. The dollar inflation risk is quite complex, but
again, it helps that the dollar is a very special currency, the
reserve and that currencies only strengthen and weaken vs other
currencies. If, for example we compare the USd with the Canadiand, a
fairly stable relationship, a large trade partnership, we can see that
the risk of buying UST for Canadians is lower, interms of currency,
than buying them from Brasil where the Brasilianr is volitile vs the
USd. In any event, the currency is a complex book, the infaltion not
so complex. If you put money in the bank at 1% and inflation is 5% you
are losing money. So, as safe as the bank may be, say a AAA rated bank
(believe it or not Wells Fargo is a AAA), the inflation risk is still
a factor and to reduce the inflation risk an investor may need to take
on other risks, like credit risk. Market Risk rules. While the credit
risk is obviously something investors are now not as confident about
(how id Wells Fargo AAA, when UST is AA+ ? Now that is a story since
the UST saved WF and WG+F paid UST back with a nice little gain for
UST, but the markets do not like the bank, or banks period so...Market
risk. Market Risk is tied to liquidity risk. Right now, the markets
are saying that the credit risk of UST is a non factor, but the market
and liquidity factors dominate. So buy UST. The infaltion risk is
almost zero. Will the curve invert? When? That is the question.