Sovereign Spreads Challenging Cherished Notions
A few years ago, I pointed out in a column that the cost of insuring the US government against a default in the credit derivatives market, had risen above that of McDonalds, the US fast food company, for the first time.
Back then, in 2008, it seemed a shocking development. After all, Western finance has traditionally assumed that governments were the safest entities in the markets; indeed the yield on US Treasurys was considered the “risk free” benchmark. Thus paying more to insure loans to Uncle Sam than those to Ronald McDonald (or any other company) seemed distinctly bizarre.
No longer. At the end of last week, trading in the credit derivatives markets implied that no less than 70 large US companies are now considered a better credit bet than the American government, according to Markit data. More specifically, the cost of insuring US government bonds against default for five years is currently trading around 50 basis points (meaning it costs $50,000 a year to insure against default for $10 million of bonds), while the cost is less than 30bp for companies such as AT&T , New Cingular Wireless and Oracle . The spread for Google , HP, Coca Cola – and, yes, McDonald’s – is also well below the sovereign spread.
And this is not just an American pattern: the credit default swapspreads for Telefonica and Iberdrola in Spain, for example, are also now well below that of their government. The idea that large companies are safer than governments, in other words, is no longer such a bizarre aberration in the derivatives world; on the contrary, it is almost accepted.
Now some people might argue that this simply shows the danger of relying on CDS as a credit guide. After all, the market for many CDS contracts is thin. Thus prices can be erratic. Indeed, Creditsights, an industry newsletter, reckons that at present only eight US CDS contracts currently have net notional values in the market of more than $5 billion, and just 27 more than $2 billion.
However, the CDS world is not the only place where the relative safety of companies and governments is changing. When Standard & Poor’s, the US rating agency, removed the AAA rating from US sovereign debt two weeks ago, for example, it left the AAA rating for four US companies unchanged. Thus Automatic Data Processing , ExxonMobil , Johnson & Johnson and Microsoft are now rated higher than their own government – a pattern that used to be largely seen just in emerging markets.
And if you dig into the reasons why those CDS rankings have changed – or why S&P left those four American companies rated above the government – it reveals some fascinating longer-term structural shifts. One way to read this trend is that it presents a verdict on relative levels of corporate governance, and transparency. More specifically, the reason why so many large companies command tight CDS spreads is that investors feel confident that they understand their balance sheets, and that these entities have plenty of cash on hand, and tangible, easily tracked revenues.
Sadly, however, many public entities currently lack that sense of transparency; on the contrary, it is painfully hard to disentangle where the liabilities and tangible assets lie. Hence the high(ish) level of CDS spreads for US Treasurys: although investors know that America is highly unlikely to default on its bonds, the political climate is so volatile that it is hard to predict cash flows. However, a second factor is the issue of globalization. Most of America’s best-run and healthiest companies these days are not really “American” anymore; on the contrary, they draw a growing proportion of their revenues from outside America’s shores, and hold vast pots of cash overseas.
That gives them the ability to hedge themselves against an American, or Western, economic downturn; or, to put it another way, they can flee, with their cash if economic or political circumstances turn sour. So can many “European” companies; just look, for example, at the global nature of “Greek” shipping lines, or those “Irish” information technology groups. However, that option is not open to public sector entities; for better or worse, their credit risk is tethered to the West.
Now, this swing may yet turn out to be temporary. And it should be noted it has not really affected actual funding costs yet: irrespective of CDS prices, the US government is still able to borrow money in the bond markets more cheaply than large American companies, including the 70 which now have tighter spreads. But, if nothing else, that 70-strong list shows again the degree to which the fall-out from the financial crisis is challenging some cherished 20th century ideas in finance. Investors should take note. Not to mention Western politicians.