Who is the largest debtor in the world? The U.S. federal government, of course. As of October 6, 2010, the national debt was more than $13 trillion, more than $1 trillion of which accrued in 2009 alone. About half of the outstanding U.S. government debt is held by the U.S. Federal Reserve and other U.S. intergovernmental bodies, and another quarter is held by foreign investors. Interest on the national debt is one of the largest items in the federal budget, totalling $383 billion in 2009. With Congressional Budget Office estimates projecting that from 2010 to 2019 the cumulative deficits will exceed $7 trillion, the federal government has a huge need for outside financing, which dwarfs the capital needs of any corporation. To feed this huge demand, the U.S. Treasury Department can issue T-bills, debt securities that mature in less than 1 year, Treasury notes that mature in 1 to 10 years, Treasury bonds that mature in more than 10 years, and savings bonds. Treasury securities can be purchased at banks (EE- and I-series savings bonds), at public auctions, and through Treasury Direct, a Web based system that allows investors to establish accounts to conduct transactions in Treasury securities online. Despite the government’s massive past and projected future deficits, U.S. Treasury securities are still regarded as the safest investments in the world. In this chapter, you’ll learn about the pricing of these and other debt instruments.

1.Despite the government’s massive past and projected future deficits, U.S. Treasury securities are still regarded as the safest investments in the world. Do you agree with this statement? Why/why not? What makes this true? What gives you concern about this?

I-Bonds Adjust for Inflation

One of the disadvantages of bonds is that they usually offer a fixed interest rate. Once a bond is issued, its interest rate typically cannot adjust as expected inflation changes. This presents a serious risk to bond investors because if inflation rises while the nominal rate on the bond remains fixed, the real rate of return falls. The U.S. Treasury Department now offers the I-bond, which is an inflation adjusted savings bond. A Series-I bond earns interest through the application of a composite rate. The composite rate consists of a fixed rate that remains the same for the life of the bond and an adjustable rate equal to the actual rate of inflation. The adjustable rate changes twice per year and is based on movements in the Consumer Price Index for All Urban Consumers (CPI-U). This index tracks the prices of thousands of goods and services, so an increase in this index indicates that inflation has occurred. As the rate of inflation moves up and down, I-bond interest rates adjust (with a short lag). Interest earnings are exempt from state and local income taxes, and are payable only when an investor redeems an I-bond. I-bonds are issued at face value in denominations of $50, $75, $100, $200, $500, $1,000, $5,000, and $10,000. The I-bond is not without its drawbacks. Any redemption within the first 5 years results in a 3-month interest penalty. Also, you should redeem an I-bond only at the first of the month because none of the interest earned during a month is included in the redemption value until the first day of the following month. The adjustable-rate feature of I-bonds can work against investors (that is, it can lower their returns) if deflation occurs. Deflation refers to a general trend of falling prices, so when deflation occurs, the change in the CPI-U is negative, and the adjustable portion of an I-bond’s interest also turns negative. For example, if the fixed-rate component on an I-bond is 2 percent and prices fall 0.5 percent (stated equivalently, the inflation rate is –0.5 percent), then the nominal rate on an I-bond will be just 1.5 percent (2 percent minus 0.5 percent). Nevertheless, in the past 80 years, periods of deflation have been very rare, whereas inflation has been an almost ever-present feature of the economy, so investors are likely to enjoy the inflation protection that I-bonds offer in the future.

1.What effect does an inflation-adjusted interest rate have on the price of an I-bond in comparison with similar bonds with no allowance for inflation?

2.How does the issuer of I-Bonds (U.S. Treasury) compensate themselves for the additional feature that is provided by I-Bonds?

Can We Trust the Bond Raters?

Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings play a crucial role in the financial markets. These credit-rating agencies evaluate and attach ratings to credit instruments (for example, bonds). Historically, bonds that received higher ratings were almost always repaid, while lower rated, more speculative “junk” bonds experienced much higher default rates. The agencies’ ratings have a direct impact on firms’ cost of raising external capital and investors’ appraisals of fixed-income investments. Recently, the credit-rating agencies have been criticised for their role in the subprime crisis. The agencies attached ratings to complex securities that did not reflect the true risk of the underlying investments. For example, securities backed by mortgages issued to borrowers with bad credit and no documented income often received investment-grade ratings that implied almost zero probability of default. However, when home prices began to decline in 2006, securities backed by risky mortgages did default, including many that had been rated investment grade. It is not entirely clear why the rating agencies assigned such high ratings to these securities. Did the agencies believe that complex financial engineering could create investment-grade securities out of risky mortgage loans? Did the agencies understand the securities they were rating? Were they unduly influenced by the security issuers, who also happened to pay for the ratings? Apparently, some within the rating agencies were suspicious. In a December, 2006 e-mail exchange between colleagues at Standard & Poor’s, one individual proclaimed, “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

1. What ethical issues may arise between rating agencies and the companies that they rate?