As you probably know, PIMCO's Bill Gross has in recent months given changing and contradictory views on the attractiveness of US Treasury securities. Late last year, he wrote that US debt was to be avoided because of rising debt levels and declining ability to service the debt load. In contrast, in the past few weeks news stories indicated that PIMCO had changed course and increased holdings of US Treasuries as being more credit-worthy and offering less interest rate risk than the sovereign bonds of the more developed European nations.
These stories did not explain the time horizon of this shift in PIMCO's allocations -- whether it reflected some fundamental shift in the attractiveness of US debt, or rather a reflection of the relative attractiveness of the US in reaction to the sovereign debt crises on the periphery of the European Union. PIMCO clarified an important part of this issue in a recent commentary published on its website.
It turns out that PIMCO is insuring the sovereign debt of G-7 nations rather than buying their bonds outright. PIMCO does this by writing credit default swaps on the sovereign debt of these nations, by which PIMCO collects premium payments from the counterparties and promises to indemnify them should they suffer default by the issuers.
This means that PIMCO is not exposed to the interest rate risk on G-7 bonds, but it is betting that the G-7 nations will not default on their sovereign debt.
This seems a neat way of separating interest rate risk from default risk.
This also implies that PIMCO is serious when it predicts that increasing debt loads will lead to higher interest rates on the bonds of the developed nations. This also implies that PIMCO is serious in believing that the risk of default is very low among the G-7 nations.
This still leaves room for a lot of market upsetting conditions to come, including ballooning debt and falling bond prices, and for personally unpleasant conditions, such as higher taxes and reductions in government services due to fiscal austerity.
