Jul 28, 2010
Does the deteriorating financial condition of the U.S. government diminish the appeal of U.S. Treasury securities as a risk-free asset? Should investors consider adding government securities from other countries to diversify?

EFF/KRF: TIPS aside, U.S. Treasury bonds and the government bonds of other countries are not now and never have been risk-free since they are subject to inflation risk. Given the current borrowing binges of governments, the temptation down the road to use inflation to kill the value of these nominal promises will be strong. But if the market is efficient, compensation for inflation risk should be built into the prices and expected return of nominal bonds.

If inflation risk is an overriding consideration in your fixed income investments, you should probably consider TIPS. Though TIPS do not have inflation risk, they do have some real return risk. (See our earlier post on TIPS.)

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to Dimensional Fund Advisors LP.