Those of us who attended economics classes dutifully recorded in our notebooks that the returns on obligations of the U.S. Treasury were the “proxy for the risk-free rate of return.” They provide a foundation to which “risk premiums” could be added in order to approximate higher expected rates of return for the universe of inherently riskier financial assets.

With federal spending relative to GDP reaching levels not seen since World War II, Congressional leaders and the President have stitched together a last minute package that will avoid default on U.S. debt by increasing the statutory debt ceiling. If there is a silver lining to all the political drama, it is that investors and taxpayers might now be more amenable to AIER’s long-held contention that no financial obligation, sovereign or private, is risk-free, certainly in a world in which money itself is not sound. Despite our best efforts to educate our readers, the best teacher is the market itself.

Though it appears technical default will be avoided – assuming the House and Senate approve the deal—it is not at all clear that Treasury debt will avoid a downgrade by credit rating agencies, nor is it clear what the impact of a downgrade might mean. The deal ostensibly cuts $917 billion over ten years, with potential for $1.7 trillion in additional cuts. But Standard and Poor’s, for example, had stated that only a plan that reduces budget deficits by at least $4 trillion dollars over 10 years would avoid a downgrade from AAA to AA.

How might the markets react to a downgrade? The fact is that we are in uncharted territory. The solvency of a sovereign nation with $14 trillion in debt that accounts for 25 percent of global economic output is in question. One could look to prior credit downgrades of other developed nations. In the 1990s Canada saw its bond yields shoot up 0.80 percent when its ratings went from “negative watch” to a formal downgrade. But Japan (1998) had the opposite experience; yields on its ten-year bonds fell 0.70 percent after a negative was followed by an official downgrade.

AIER has reviewed empirical models that go beyond anecdote. The impact of a downgrade would be widespread; many governmental and private entities are bound by statute or charter to sell securities that lose their AAA rating; estimates suggest Treasury yields could rise by as much as 0.50 percent in response.

On the other hand it has been argued that credit agencies add value and help in price discovery in those markets where information is costly to obtain, such as obscure private debt or municipal bond markets. But there is little relevant information that has not been divulged regarding the probability or magnitude of a default on U.S. debt, so the impact of a downgrade on yields might in fact be very limited, to the extent it would represent just one more opinion regarding information already well-publicized.

Though the risk of U.S. default is new, our advice to you is not. No asset is “riskfree” and in an uncertain world, there is no substitute for diversification. The portfolios we recommend, based on the funds found on page 56, represent over 5,300 common stocks spread throughout the world, 2,700 bonds, as well as gold and gold-mining companies that hold over 40 percent of the world’s known gold reserves.

Also In This Issue

Focus On Commodities
Quarterly Review Of Investment Policy
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow Jones Industrials Ranked By Yield
Recommended Investment Vehicles