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U.S. Treasury Default Options

Monday May 16th, 2011   •   Posted by Emily Skarbek at 7:49am PDT   •  

Charles Rowley summarizes two options facing bond holders as sketched out by Stanley Druckenmiller, the legendary investor and onetime fund manager for George Soros.

“First, suppose that one owns a 10-year Treasury. In return, one receives an income stream over that period. As a result of default that income stream will be delayed for some period of time, until market pressures force the government to clean house. In return for that delay, one receives significant cuts in entitlements and the government gets its house in order. In consequence, one’s income stream almost 10 years out is much more assured.

Second, suppose that one owns the same 10-year Treasury. However, in this scenario, the debt limit is quickly raised to avoid any disruption of payments. One receives one’s income on time. But the government continues to pile up trillions of dollars of debt, and a Greek situation emerges say six years down the road. One’s income stream is rendered worthless.

I would note that in the second scenario, there are several ways the government could render one’s income stream worthless and inflation just allows the culprits to escape responsibility. Given the trade-off, raising the debt ceiling is a very bad deal.

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May 2011