Following the recent decline in Libor rates, the yield (10%) on Warren Buffett’s preferred stock investment in General Electric (GE) and Goldman Sachs (GS) is now appearing to be entirely in line with the evolving reality of corporate debt: that effective interest rates should incorporate perceptions of default risk. But bond traders in the US marketplace are obviously unwilling to accept that credit default swap spreads should be playing an integral role in determining yields for longer-dated General Electric and Goldman Sachs maturities.
To reconfirm a trend witnessed in the recent financing structures for FirstEnergy Corp. (FE), Nokia (NOK) and Nestle [NESN.VX], Borse Dubai Ltd., the state-owned operator of exchanges, is now in talks with bankers to refinance $4.2 billion of loans at a cost of 6%-plus over Libor, a cost derived from the CDS spread on Borse Dubai, in addition to the cost of funds. Last year, Borse Dubai was able to raise money at a margin of 1.1% over Libor when it purchased Sweden’s OMX AB.
Late Tuesday, General Electric’s 2012 and 2013 (GE.HDS and GE.HDJ) bonds were yielding 6.05% and 6.39% respectively. Goldman 2012 [GS.KW] changed hands around 7.50%. But if buyers had factored in credit default swaps, they would be demanding an additional spread of 150-200 basis points, at the very least, on both issuers. Some market-makers have been justifying the yields on GE, Goldman and other investment grade bonds from the prism of further Fed action to lower benchmark rates. Such action, however, would be predicated on more bad news on the domestic and global front, news which would drive CDS spreads higher anyway.
The fact that CDS traders continue to price GE credit default swaps in the 420-450 range is already an indication that the derivatives segment of the market doubts the viability of GE’s superior credit rating. Any suggestions that a deep, prolonged recession will force GE to revise its guidance for 2009 earnings will certainly cause a breach of the critical 500 level within short order. In that case, the potentially positive influence of Fed rate cuts on GE bond yields will be nullified.
On Tuesday, CEO Lloyd Blankfein claimed that Goldman Sachs was “as well positioned as any” financial services company to meet the challenging near-term environment. Mr. Blankfein failed to provide any supporting analysis for his targeted 20% return on equity as and when the markets “revert to normal”. When and if the 20%-return prospects are visible to investors on the horizon, Goldman CDS spreads may well narrow within 250 basis points. Until then, Tuesday’s yields represent a significant pricing misalignment. Without doubt, prudence dictated vagueness in a climate where Mr. Blankfein is not alone in being overwhelmed by the sheer power of the unknown.
It is exactly that unknown element or variable risk (in pricing terms), which an efficient CDS mechanism should seek to capture; details governing credit and rating events in the Borse Dubai, FirstEnergy, Nokia or Nestle swaps have not been disclosed, though sources close to the transactions point towards tighter mark-to-market rules, rigid credit and rating parameters and, finally, even clauses implying changes in agreed-upon CDS spreads under certain specific conditions.
Disclosure: Author holds short positions in GE and GS