The U.S. long bond market is experiencing the fruits of a move away from risk taking. How you say? Regardless of its $14+ trillion funded debt and at least $63 trillion in unfunded liabilities, the U.S. remains, in the minds of many, a safe harbor. Whether you personally agree with that statement is not important. What is important is how the market acts and presently it is favorably disposed to long-term U.S. debt. This writer is not and prefers the short end of the curve (like T-Bills). Investors are less anxious to chase higher yields and seek the perceived safety of U.S. debt. Are investors aware of the deterioration of sovereign U.S. debt?
One measure of perceived credit risk (safety) is the Credit Default Swap (CDS). The CDS rate is an insurance policy of sorts on credit instruments like bonds. The CDS rate measures the cost of insuring $10 million of a credit instrument for five years. For example, last month it cost 55 basis points (bp) to insure sovereign U.S. debt. Translation: It cost $55,000 per year ($275,000 for five years) to insure $10 million of U.S. Government debt. [Note: in Escaping Oz, I cited a figure of 39 bp relative to June 30, 2010.] By comparison, the CDS rate for Japan was 145 and for Germany, 107. Uncle Sam still means less risk.
Is Uncle Sam, though, still considered the lowest risk around? The pharmaceutical company McKesson Corp. had a CDS rate of 47. The market believed a private U.S. company to be a lesser risk than the U.S. Government over a five-year period. It’s not just a private company but even another country that until recently had a lower CDS rate than the United States. The Kingdom of Sweden’ s CDS rate was quite comparable to the U.S. figure. Let’s look at the other end of the spectrum. Energy Future Holdings (formerly TXU Corp.) recently had CDS rate of 4886 to insure a $10 million credit instrument. Energy Future Holdings may have been a company that investors chased for yield. If they chase this company now, the market says it is quite a risky play.
There are a few salient points to make here. First, while the U.S. is still considered a good credit risk, it is not as good as it once was; witness the CDS deterioration from 39 to 55 in a 15 month period. Second, even with the deterioration of the U.S. rate, it is still considered a better risk than other countries. Third, the August downgrade by ratings agency Standard & Poors did little to dampen investory appetite for bonds – bonds actually took off immediately after the downgrade. Lastly, a private company can now be seen as a better credit risk than the mighty U.S. Government (USG). I believe there will be more private companies that will be viewed as more fiscally responsible than the USG in the coming years.
This is a very confusing time for investors. The recent increase in bond prices is a reflection of the fear component in the markets. When a country can have its sovereign debt downgraded, witness its CDS rate increase, and see an increased demand for its debt we know we are in an environment fraught with financial uncertainty. The ultimate trust in the Wizards issuing this sovereign debt will be broken and the aftermath will be ugly.
Jim is the author of Escaping Oz: Protecting your wealth during the financial crisis and is the editor of The Sentinel Financial Report.