Think Corporates Are A Safe Haven? Think Again

Yields on some corporate bonds are trading below their U.S. Treasury counterparts suggesting dwindling credit risk in the bond market according to the Wall Street Journal. In the article “The New Haven for Investors”, the authors wrote that it is a sign that “investors perceive them as a safer bet.” Furthermore, they wrote that some market observers think that this could be the “beginning of a new era for debt markets” which means that companies will have lower rates than their home country.

In all of my years as an institutional fixed income portfolio manager, nothing surprises me. What we are seeing is not a signal of a “new era” for the corporate bond market but a case of too many people chasing too few assets.

Companies rated ‘AAA’ like Johnson & Johnson (JNJ) and Exxon Mobil (XOM) are without a doubt, safe companies. From what I can see, they are worthy of their ratings or at the very least, show a low probability of default. That probability drops even further when you account for the maturity of the bonds. To borrow part of a phrase made popular by our friends at Zero Hedge, if given a long enough time frame, a company’s survival rate drops to zero and the default probability increases. Shrink that time frame by way of the bond’s maturity, and the default probability falls with it. As we all know, this should lead to a drop in the yield or more precisely the credit spread or yield differential between the two short maturity bonds.

Having said this, it is not surprising that yields on these highly rated companies converge with their U.S. Treasury counterparts on this part of the yield curve. If I had to quantify it, I would say that their default probability given their rating is just a tad above zero. For most people and in the grand scheme of things, it is pretty close to nil which partly explains the low level of yields. But to infer that a company is “safer” over a sovereign is just plain wrong.

When it comes down to it, default risk is determined by the borrower’s ability to pay off that debt. A corporation’s ability is determined by revenues and profits which is completely contingent on demand from its client base. If a client likes a company’s product, they will buy more which means increasing revenue and cash flow where they can service their debt with ease. Hence, a company’s solvency and likelihood of default is at the mercy of its client base’s wills and desires for their product. In other words, they are price takers in determining their likelihood of default.

For the U.S. government, their ability to pay off that debt is determined by their ability to tax. While higher taxes may upset some people, their ability to do so is ultimately up to the government. This includes taxing individuals and corporations like Johnson & Johnson and Exxon. Furthermore, the U.S. Government is not a country like Greece that is facing a debt problem since the U.S. controls its own currency. This suggests that for the U.S., the “printing press” is a means to service its debt. So, if you rule out a complete collapse of the country’s way of life, the conditions for a true default are completely left to the U.S. Government. In this context, they are price makers.

Does that mean that the U.S. cannot have a technical default where the timely repayment of principal and interest on their debt is compromised? The answer is no.

Does that mean that if there is a technical default on the U.S., is debt on U.S. corporations a better bet? The answer to this is an even bigger NO! If there is a technical default, the markets would see equities tank, and that would lead to wider corporate spreads. Of course spreads would widen more than others depending on the credit quality. In any case, most corporate bond would be negatively affected by rising risks and volatility spurred by a U.S. Treasury default.

In the case of these short dated corporates trading on top of Treasuries, it is difficult to determine exactly what is driving this. Let’s face it. The markets are driven by people who in turn, are motivated by a variety of factors. To be able to accurately determine the cause of the convergence of these corporate bonds with Treasuries is to intimately know the objectives of bond investors that focus in this space.

A great example of the variety of factors is that you can have bond managers who both believe that yields will head higher but position their portfolio differently. A total return manager of a hedge fund or ETF will sell their holdings and go to cash. Here they are maximizing return and taking on risk. Another manager who manages both equities and bonds may do the opposite and buy bonds after the initial selloff since their current positions fell in market value. This discipline in rebalancing to maintain a fixed allocation to bonds takes precedence over a portfolio manager’s view on higher interest rates. The process over price gain determines their actions. A portfolio manager of an insurance company may not even flinch despite their bearish outlook simply because their liabilities dictate their portfolio positioning. Here, risk control over price gain dictates their actions.

That said, my guess is that money market bond investors who are flush with cash are driving up the price of these corporates simply because they have nowhere else to go. As we mentioned before in our post “The Federal Reserve Does Not Care If Treasury Rates are Higher”, the Federal Reserve’s latest Quantitative Easing program is a huge driver of demand. The Fed’s purchases of Mortgage Backed Securities, after all is said and done, will undoubtedly overwhelm the amount of new issuance for most taxable bonds which may result in a net supply of zero or perhaps even negative. A money market bond investor who needs to buy but is having a hard time finding bonds will pay up so he can stay fully invested.

In addition, the European Debt Crisis and the potential of contagion to the financial sector may drive away money market players from investing in European banks' commercial paper programs. This may lead investors to seek their returns elsewhere and drive up the price in limited supply securities like the aforementioned short dated corporate bonds.

Whatever the case may be, what we are seeing should look familiar since long time bond investors will know that we have traveled down this path before where the incremental yield between safer and riskier bonds compresses.

Prior to the Long Term Capital Market debacle back in the late 1990s, an investor could own Merrill Lynch 5-Year bonds with a ‘AA’ rating at 60 basis points over Treasuries while pick up an additional, miniscule 5 basis points to go to the bottom end of the investment grade scale by buying Lehman Brothers 5-Year bonds.

Back in 2006, bond investors could buy so called ‘AAA’ subprime bonds for 25 to 30 basis points over LIBOR. Credit spreads were tight simply because investors were desperate for return and needed bonds. Carry was king, and the objective of remaining fully invested over risk control determined their actions. As we all know from the financial crisis, the spread on these instruments did not stay at that level for very long.

Common sense and experience tells me to not read into short dated corporates trading below U.S. Treasuries. Corporate issuers are not safer than U.S. Treasuries and the market is not about to embark on a “new era.” Also, this isn’t a sign that the default probability of U.S. Treasuries is increasing because of the country’s budget problems. In fact, I would look to a falling dollar if that is indeed the case.

Furthermore, if I were an owner of said corporate bonds, I would sell JNJ and XOM bonds and buy U.S. Treasuries. Yields may trade below Treasuries and this may continue going forward given the Fed’s influence on demand. However, the upside should be limited while it is just a matter of time before corporate spreads widen.

As illustrated by the two examples, it has happened before and will happen again and is far from anything new. The fact that history repeats itself in some form or another where corporate spreads widen is probably the safest of bet of them all.

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