In recent weeks, some market commentators have asked a question that would once have seemed unthinkable. Should government bonds still be viewed as risk free? If a negative answer is anywhere near possible it has huge implications.
The question has become more urgent following the recent credit downgrade of Greece on concerns over its public debt burden. The broader debate has focused upon banks and their holdings of Treasuries, gilts and the like as Basel I assigns a zero risk weight to government bonds - the assumption being that they are without risk. But what are the implications for the other holders of government debt?
Why do, or why should, lenders provide funds to governments? While it might be nice to think that there are good social reasons for doing so the reality is that for many with capital to allocate, an allocation to government debt is in some ways mandatory. It is for reasons of regulatory capital requirement as far as banks are concerned. For institutional investors and other market participants, government debt is assumed to be the sole risk-free asset and has therefore been the cornerstone of capital allocation and diversified investment portfolios for many years.
