Some call the graphic below the most important chart in the world right now.

The chart is from this report by the Bank for International Settlements (BIS) and Basel Committee.  There are three things I’d like to point out and briefly comment on.

First, AAA-rated fixed income issuance exploded from $1.5 trillion in 1999 to more than $6 trillion in 2009 – a 300% increase!   From 1990 to 2006, growth was driven by asset-backed securities (ABS), but issuance declined in 2007 and 2008 as investors learned that AAA-ratings were given to subprime securities that didn’t deserve them and the financial crisis ensued.  After declining for two years, AAA-rated issuance surged in 2009 due to a flight to quality among investors, crazy low interest rates, and government stimulus efforts. 1,448.29

The second thing I notice is the surge in sovereign debt as a proportion of AAA-rated issuance.  Lower tax revenues and the need to fund stimulus measures during the recession led governments to issue more debt.  At the same time, investors shunned ABS (for obvious reasons) and flocked to sovereign debt, which was considered a safer bet.  In addition, central banks began accepting government debt as collateral at liquidity facilities and later made outright purchases of government bonds (QE), thus further absorbing the increased supply of sovereign debt.

The third thing that really sticks out to me is that more than half of the fixed income market is considered to be risk-free.  Is this a problem?  At the most basic level, creditworthiness comes down to willingness and ability to make debt payments.  With sovereign debt, the concern isn’t a question of willingness to repay, but ability.  Interest rates are at record lows today, which make servicing large debts manageable.  However, things could get pretty stressful for some nations if interest rates were to rise suddenly. 

At current debt levels, a 0.25 percentage point increase in interest rates on U.S. debt would cost taxpayers roughly $363 billion annually.  That is exactly why there is so much focus on the U.S. deficit.  It is also why the ratings agencies have warned that the U.S. credit rating will be cut if an agreement isn’t reached.  Fortunately, it appears some progress is being made on raising the debt ceiling and agreeing to a deficit reduction plan.

Thanks for reading,

Peter Lazaroff

Acropolis Investment Management

www.acrinv.com