The academic economist’s view of asset pricing is that asset prices are set as an interplay between discount factors and expected stream of future returns (See Cochrane’s "Asset Pricing" textbook for example). These discount factors are not just about risk, but about how the payment stream correlates with how the buyer of the asset is doing. Take a simple example: one can have two assets with the same risk (standard deviation), paying $3 half the time and $1 the other half of the time, but the asset price for the one that pays out $3 in bad times and $1 in good times will be higher than for the asset that pays out $3 in good times and $1 in bad times. Why? Because when times are bad (and you are more likely to be unemployed as a individual or have bad sales as a business) you want to have $3 more than you want to have $3 when times are good, and having $1 in bad times is very bad while having only $1 when times are good is ok. So, it’s not just about risk, but about how the riskiness of the asset corresponds to the buyer’s circumstances. Usually we can talk about risk being bad because usually the risks are correlated so for most things they do badly all at the same time and the risks are correlated, so we’d rather have less variability rather than more given those correlations.
However, that does present some interesting opportunities for institutions that don’t face the same issues. Take university endowments for example: since universities are institutions often will ensure forever, or at least over the course of centuries, they can have a longer window and ride out market downturns. Keynes, who ran the endowment at Cambridge (a university since 1231, coming up on their 800th anniversary in about a decade) pioneered investing in equities rather than sticking to fixed-income purchases which was the norm for universities, a good strategy for such a long lived institution who can ride out market downturns. Modern university endowments often invest in highly illiquid assets like forests that carry lower prices due to their illiquidity, but since university almost never need to sell quickly, the illiquidity is less of a problem for them. Individuals are not so lucky and may be forced to sell in downturn if they face unemployment or other cash flow issues. These kinds of conditions are more likely to prevail when equity prices are lower, explaining why equities tend to have a return premium over bonds: they are risky in a bad way, while bonds are risky in a good way.
However, we could think about another institution, the government, that can often endure for centuries. Because the government can create new money and force people to pay taxes, they are the institution best able to continue to provide cash flows through either the Treasury or the central bank. As a result, we naturally see a tendency for US government bonds to rise in price when there is a crisis, as everyone rushes to the safety of government payments streams. This does not hold for emerging market government debt, which is more likely to default in a crisis, just like corporations are. This is why U.S. Treasury bonds are safer in a crisis: the cash flow resulting from them don’t fall in a crisis, and so their prices rise, further improving their asset prices as this price increase occurs at opportune times.
The US Treasury could lean in to these circumstances take advantage of their advantageous cash flow position by offering securities that pay out more in crises or recessions. This would be preferred by asset purchasers facing these risks, even though in a statistical sense the payouts of these assets would be more “risky” as they would have a higher standard deviation than regular Treasury debt.
These assets should have two primary benefits:
(1) Increasing cash payments to the private sector when they are most needed- in a financial crisis or recession.
(2) Selling for a higher price as they have an insurance role in increasing cash flows when they are most appreciated.
One issue with perpetual bonds like consol bonds is that they generally sell for relatively low prices, as the uncertainty over conditions in the distant future is very large. However, a consol bond that pays out 2x, 3x, 10x, etc. in periods when the NBER declares a recession or when there are emergency Fed actions consistent with a financial crisis would raise the price of these consol bonds, and provide an automatic structure to forever increase cash transfers to the private sector in a recession or financial crisis. Now is the time for crisis consols!
However, that does present some interesting opportunities for institutions that don’t face the same issues. Take university endowments for example: since universities are institutions often will ensure forever, or at least over the course of centuries, they can have a longer window and ride out market downturns. Keynes, who ran the endowment at Cambridge (a university since 1231, coming up on their 800th anniversary in about a decade) pioneered investing in equities rather than sticking to fixed-income purchases which was the norm for universities, a good strategy for such a long lived institution who can ride out market downturns. Modern university endowments often invest in highly illiquid assets like forests that carry lower prices due to their illiquidity, but since university almost never need to sell quickly, the illiquidity is less of a problem for them. Individuals are not so lucky and may be forced to sell in downturn if they face unemployment or other cash flow issues. These kinds of conditions are more likely to prevail when equity prices are lower, explaining why equities tend to have a return premium over bonds: they are risky in a bad way, while bonds are risky in a good way.
However, we could think about another institution, the government, that can often endure for centuries. Because the government can create new money and force people to pay taxes, they are the institution best able to continue to provide cash flows through either the Treasury or the central bank. As a result, we naturally see a tendency for US government bonds to rise in price when there is a crisis, as everyone rushes to the safety of government payments streams. This does not hold for emerging market government debt, which is more likely to default in a crisis, just like corporations are. This is why U.S. Treasury bonds are safer in a crisis: the cash flow resulting from them don’t fall in a crisis, and so their prices rise, further improving their asset prices as this price increase occurs at opportune times.
The US Treasury could lean in to these circumstances take advantage of their advantageous cash flow position by offering securities that pay out more in crises or recessions. This would be preferred by asset purchasers facing these risks, even though in a statistical sense the payouts of these assets would be more “risky” as they would have a higher standard deviation than regular Treasury debt.
These assets should have two primary benefits:
(1) Increasing cash payments to the private sector when they are most needed- in a financial crisis or recession.
(2) Selling for a higher price as they have an insurance role in increasing cash flows when they are most appreciated.
One issue with perpetual bonds like consol bonds is that they generally sell for relatively low prices, as the uncertainty over conditions in the distant future is very large. However, a consol bond that pays out 2x, 3x, 10x, etc. in periods when the NBER declares a recession or when there are emergency Fed actions consistent with a financial crisis would raise the price of these consol bonds, and provide an automatic structure to forever increase cash transfers to the private sector in a recession or financial crisis. Now is the time for crisis consols!