Thursday, April 14, 2011

Can Corporates Trade Through Sovereigns?

I am cross-posting here and on Davian, the technology and marketing partner for my autotraded inflation product for retail investors.

There has been some discussion regarding the spread of corporate bonds over treasurys, and, more widely, can corporates trade “through” sovereigns, that is, can corporate bonds yield less than the government bonds of their domicile?

For starters, it is already happening in the periphery of the eurozone.

Greece’s 5-year is at over 15% as I write this, while Coca-Cola Hellenic, a Greece-based bottler, is paying 4.xx% for their 5-years. This is a full 1,100 bps under the Greek sovereign. (Of course, CCH is international and backed by KO's credit implicitly)

Can it happen here? At this stage, no. The US is not Greece as the US can both borrow and print in its own currency. Greece has not had the drachma for years and its borrowing is in euros. There is no reason for the US to default on obligations in its own currency: most holders are domestic, and defaulting would mean the near-certain end of pensions plans, numerous financial institutions and insurance companies who are legally required to hold a lot of US credit instruments. The other option is to pay back in nominal, but not in real terms: this is the path we are on.

However, what would happen if the US cannot issue dollar-based debt? This is a possibility, few countries in the world have the luxury of borrowing in their own currency, and we have certainly abused this privilege (along with the privilege of having the main reserve currency).

If the US has to borrow in SDRs or in currency X, I do think that high quality corporates in the same currency will be trading substantially lower than the US debt. Why?

Let’s review the 5 C’s of credit: character, capacity, capital, conditions, collateral. I will focus on three: character, capital and collateral. Compare the US government to a large corporation on these three counts: the corporation has its books done properly with adequate disclosures of future obligations. The US is not even putting GSE debt on its balance sheet, let alone unfunded promises. A large corporation is run, generally, by rational decision makers. Can we say the same about Congress? A large corporation has global, relatively predictable earnings stream from which to pay back debt. The US government is wholly reliant on its taxation power, something that is not nearly as predictable. Of course, the government can pledge or sell federally-owned land and other assets but I hope we won’t get there. A large corporation has well-established audit/security procedures. The US government is rife with waste.

It is clear that a well-run global corporation should be a lower credit risk than any one sovereign risk provided that the borrowing is done in a currency that neither party controls. There is no reason why JNJ or WMT or MCD have to pay a spread over Geithner & Co. It will be a major paradigm shift when it happens in the US.

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