Three reasons not to lend to governments

This is serious stuff. As I write, the FTSE 100 is down some 40 points. If it stays that way, it'll be ten down days in a row. That's the longest losing streak since 2003.

The catalyst for this stress is the global bond markets. What's going on there looks increasingly frightening. And they're weighing heavily on the equity markets.

I suspect the markets are finally beginning to see what some of us have seen for ages. That is the massive dangers presented by our over-indebted Western governments.

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Bond markets are getting to the stage where they're saying "We don't want to lend you any more money." Yet governments can't stop borrowing.

This is a disastrous dynamic. People always seem to think that lending money to government is 'risk-free'. That's why investors park their cash in gilts and treasuries. But as you can see, it turns out that it's far from risk-free.

And in fact, I'd much rather lend my money to corporations than to governments. I'll show you why today.

Western governments are hooked on debt

While Germany is undoubtedly viewed as a pretty good credit, there's a limit. And on Wednesday we found out where that limit is. In a bond sale, the government could only raise about two thirds of the cash it was after. Investors aren't prepared to lend on the scale they need. That's an ominous development.

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Marc Ostwald, strategist at Monument Securities, put it bluntly: "complete and utter disaster".

Meanwhile, over in the States we learned that the super-committee set up by Obama to cut spending reached stalemate. They can't agree on any sort of plan to cut public spending.

Of course, it's the same here on our pleasant little isle too. For all the talk of austerity, the government's still racking up massive debts. -they just can't stop spending.

Put simply, Western governments are hooked on debt. And the further the economies sink into the mire, the more money they need. More state benefits to pay and less tax coming through the door.

Of course, we've had quantitative easing (QE) to fall back on. And now it's increasingly looking like Europe will have to succumb to the printing press too. Of course they're not admitting it, but at some point they probably will.

Why I'm worried about lending to governments

Modern day finance contends that government credits are the safest. Governments don't go bust, they say. And so long as you have the power to print your own money, that's kind of true. You've always got a 'get out of jail free' card.

Of course, printing money is a cheat. Bondholders receive devalued currency. But it's better than nothing at all. That's why many are still buying government bonds.

I've held onto a reasonable amount of government bonds too though I have to confess that was more of a play on any deflation down the line. But I'm starting to capitulate. The risks and returns just don't stack up anymore. I'm increasingly turning to corporate bonds.

Today I want to give you three reasons why I think corporate bonds are a better bet.

1. The law is on the government's side

In many countries, politicians are commonly known as 'lawmakers' and you shouldn't forget that. They have the power to change the law as they see fit. Obviously that puts lenders to government in a tricky position. Governments can make the rules up as they go along!

Of course, governments won't want to upset voters and seeing as many voters are bondholders via pension funds you'd think governments wouldn't want to screw them over. But it all comes down to perception. Much of the public are woefully unaware of how their pensions work. When faced with tax hikes or 'screwing the banks' they're likely to vote for the latter. Blissful ignorance!

If you want to see how rules get re-written then just look at Greece. They've obviously defaulted on their bonds I mean, a 50% 'haircut' for bondholders! But it's worse...

The authorities also claim there's been no bankruptcy only a voluntary agreement to cut the debt in half. And that nuance matters for any bondholders (like pension funds) that took out insurance against bankruptcy.

In a nutshell, they won't receive a payout there's no bankruptcy remember! Paying out on these insurance policies (credit default swaps, or CDSs) would cost some elite banks (especially American ones) too dearly.

At least with a corporate bond you've got the law on your side. The guys you're lending to can't run rough-shod over your interests.

2. Strength of assets backing the bonds

When you lend to someone you want to be sure that you've got some form of security, or collateral.

What does a government have? Practically nothing! Sure, nation states have some valuables, but the bonds don't have a call over them. In all the turmoil of the European debt struggles, there's been very little action taken by governments to sell down assets.

As we saw last week, nations aren't interested in selling hard assets like gold to back their bonds.

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At the end of the day a bond is backed by the pledge from the government. But governments come and go. Take Ireland. The new government (quite rightly in my opinion) says that the last lot signed the nation up to penury just to bail out continental banks. They want debt reductions.

They want to re-write the rules. They're the lawmakers after all!

3. Better interest rates

You may say that the risks I've just defined are outliers. They're not likely to happen. Fair enough you're welcome to your view. But investment is all about risk and reward. Let's just look at the reward on offer for gilt investors.

The yield on the ten-year gilt dropped to 2.16% yesterday. Given that inflation is running at around 5%, you're guaranteed an almost 3% loss a year. Of course inflation could go up, or down from here but that's just another risk!

That looks like an abysmal return to me.

Of course, inflation will have a similar effect on corporate bonds. But with a corporate bond you start off in a very different place.

For instance, a couple of weeks back I described a corporate bond currently yielding around 12%. That means inflation can stay high and we'll still be getting a 'real' return. And that £600m bond issue is backed by real estate worth some £1,000m. The bond is backed by real assets that bond holders have got a legal claim over. Try getting that from a government.

It's time for investors to get real. No government debt is risk-free. And I suspect that at some point the markets will reflect this reality.

Corporate bonds aren't risk free either no investment is. But I would much sooner lend my money to companies like Tesco, Vodafone or National Grid than our own government. And to spice up potential returns I don't mind lending to a few risky corporations too.

Why would you lend to government for a guaranteed loss?

As the financial world becomes more uncertain, I'll try to give you the best ways I can think of to build some security into your portfolio. And that will certainly include more corporate bonds.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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