During a crisis, people invest in US bonds. However, wouldn’t a crisis increase the risk of default?

My answer on Quora:

One of the most telling and paradoxical events in the world of finance happened when Standard & Poor’s downgraded US government bonds in August 2011 for the first time ever. Instead of investors reducing their demand for a bond that is now deemed by a leading credit rating agency as riskier than previously thought, they increased demand! This goes counter to the intuition that a lower credit rating should on average reduce demand for that bond. The idea is that government bonds tend to be relatively safe investments that people invest in as a safe haven. So why did people flock to US government debt for safety when US government debt was deemed less safe? The reason is that it is still considered the safest asset out there. The fact that bond markets rallied after the downgrade couldn’t deliver that message any more clearly.

During a crisis, capital will flock to where it will be the most safe. Note that this is relative. If there is nothing with a zero percent chance of default, then the next safest asset is one with close to zero default, and so on. The US is the largest economy in the world with the deepest and most liquid financial markets. The US government is seen as the of the most stable governments (and it’s important to actively preserve that impression!) that upholds the rule of law in court (very important when it comes to financial disputes and accountability in upholding obligations) and, very importantly, it issues the world’s most dominant currency – the US dollar, the world’s reserve currency. For a deeper dive into that, see How the U.S. Dollar Tightened Its Grip on Global Finance.

 

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