20th January 2012
"Northern Trust Co. investment strategist Jim McDonald observes that it costs less to buy insurance in credit default swap markets against default of Nestlé or Exxon Mobil than to insure against a U.S. government default, and less to insure against default of Coca-Cola and Wal-Mart than against default by Switzerland or Germany. Given that governments, ultimately, have the power to tax, and companies don't, that is extraordinary."
Much of the original work was done by Credit Suisse – who calculated that the supply of assets that markets deem ‘safe' by markets has fallen to $12 trillion from $22 trillion in the past four years.
The CDS market is usually seen as a leading indicator, foreseeing crises before they become reality. This Standard & Poor's piece shows how CDS prices can be interpreted to build a picture of the inherent risk in a country or company.
This raises the question for bond investors of whether some corporate bonds are safer than the government bonds of the major global economies. It is important because if a shift has taken place it will upset the assumptions that underlie many portfolios:
"This is a striking divergence from financial custom. Company debt has historically been priced and traded at a certain premium above government debt, the so-called "risk-free rate" for which interest rate changes was the main danger, not defaults. "That corporate debt is perceived as safer than government debt in many cases is a huge paradigm shift," says Philippe Berthelot, head of credit at Natixis Asset Management. "A lot of asset classes have lost their reference point now."
The article also suggests that the differential between the ‘risk-free rate' and investment grade corporate debt is likely to narrow into 2012.
There are signs that this phenomenon is already being reflected in bond portfolios across Europe. Kate Hollis, director of fund research at S&P, says that increasing European bond managers are moving to be underweight Spain, Italy and France. They are shifting their benchmarks to ensure that they are only in investment grade government debt. She also suggests that they are moving into higher quality corporate bonds.
But before investors write off government debt completely, it is worth noting that this phenomenon may have been well-reflected in the CDS market, but it has not yet been reflected fully in the bond market. As this poster points out on the Wall Street Journal site: "I remember a few of months ago when everyone was pressing the panic button because S&P had "downgraded" the U.S. If creditor countries start to think that US treasuries are "risky" then they will sell treasuries and you will see a jump in interest rates. The fact the 10 year note is yielding <2% proves the world hasn't lost trust in US debt (yet)."
There has been some manipulation of the government bond market, which has helped maintain historically low yields, but at recent auctions plenty of demand has remained for higher quality government debt. The triumph of corporations over governments is therefore not fully complete. But it should prompt a reassessment of risk on the part of bond investors.
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