Is the USA Still AAA?

Is it possible that the U.S. Treasury could default on its bonds? Earlier this year, Standard & Poor's and Moody's, the two largest bond-rating agencies, rattled the investment world by declaring that U.S. Treasury bonds might be downgraded from their coveted triple-A rating because of large budget deficits. That means the two agenciesbelieve there's a chance that Uncle Sam will not pay all the interest or principal on his debt in a timely manner.

But the rating agencies are wrong. No matter how big the deficit, the U.S. will be able to pay interest and principal on its bonds. The reason is simple: Subject to the national debt ceiling, the Treasury can always go to the Federal Reserve and borrow an unlimited amount to pay off its debts.

Granted, such unlimited borrowing could cause serious inflation. But remember that except for a small portion of the debt that is indexed to inflation, the government's only promise is to repay bondholders with dollars. There is no guarantee whatsoever regarding what, if anything, those dollars will be worth.

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What if the Fed refuses the Treasury's request for money? Indeed, there is a law that requires the government to borrow its funds directly from investors and not from the central bank.

Yet in a cash crunch, it is Congress, not the Fed, that rules. Article I, Section 8 of the U.S. Constitution gives Congress the power to "coin money [and] regulate the value thereof." The Constitution contains no provision for a central bank, which was created by Congress in the Federal Reserve Act of 1913. So if Congress decided to abolish the Fed and take over monetary control, there could be no constitutional appeal.

That also means no corporation or municipality can ever be in a better position to pay off its indebtedness than the U.S. government. Because the Treasury can get access to as many dollars as it needs, it will always have an advantage over any firm, individual or other governmental unit that issues dollar-denominated debt.

The same is true of any country that denominates its bonds in its own currency. For that reason, S&P's recent downgrading of Japanese debt, which is issued in yen, makes no sense, either.

In contrast to the U.S. and Japan, the European Central Bank is under no obligation to bail out any debtor, even a sovereign country. But if, for example, Germany, Europe's strongest economy, were on the ropes, the ECB would most likely come through with the loans necessary to avert a default.

What About TIPS?

One valid question is whether Treasury inflation-protected securities are as secure as Treasury bonds (see ASK KIM: Skip TIPS For Now). If the government resorts to printing money to pay its obligations, that would spur inflation and require higher payments on these securities. It's possible to envision a hyperinflationary scenario in which prices rise faster than the government's ability to print notes, causing the Treasury to default on these bonds. But it's unlikely. There's a time lag in the application of the inflation rate to TIPS payments that will always allow the Treasury to come up with the required money.

Of course, whether the government can technically pay interest is secondary to the devastation that a hyperinflationary environment (think wheelbarrows full of cash) would wreak. If such an episode were to occur -- and I consider it extremely unlikely -- investors would be better off owning hard assets, such as gold, real estate and even stocks, than any sort of bond, whether inflation-protected or not.

Bottom line: The major threat to investors is not default but inflation, and that affects the returns on all bonds, both corporate and government. Inflation is the insidious, though technically legal, way in which the government defaults on its obligations.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.