What would happen if government bonds were no longer ‘risk free’

Government bonds are treated as ‘risk free’ in most portfolios. Why? Because government’s can always tax their citizens to pay interest to creditors. There’s no need to default. And, as of now, there’s no imminent risk of a default in a major economy.

But after a 30-year bull market in government bonds, and with negative interest rates on some government bonds in Europe, some investors are beginning to question whether government bonds deserve the moniker ‘risk free.’

See below from the Financial Times. Higher rates and  a shift to ‘fiscal stimulus’ could spell the end for the decades old bull market in bonds. Two big questions after that: what becomes the default ‘risk free’ asset in investment portfolios (gold), and do equities benefit if model portfolios reduce their allocation to government bonds? From the FT:

Now, the assumption that interest rates can keep falling in pursuit of higher inflation, pulling up bond prices with them, is crumbling. Relatively small pullbacks in prices can be painful and the capacity for further gains in bonds in the event of a wobble in stocks is seen as limited. Mr Saint-Georges predicts that “2020 is not necessarily going to be a binary thing — crisis or not crisis”.

But he believes it will bring a profound reshuffle in how people think about the right portfolio construction. Good quality emerging-market debt, emerging-market currencies and gold could come more into favour as hedges for when stock markets turn sour, he said.

The New-York based fund group BlackRock also said in November that it has been forced to reconsider the role that maxed-out government bonds play as “ballast” in portfolios. The see-saw relationship between stocks and bonds that has become familiar over the past two decades is at risk of breaking down. With their super-skinny or even negative yields, European and Japanese government bond markets are likely to play a “diminished role”, it added.