By Paul Amery
Does it make sense that lending to corporations is now seen as less risky than lending to governments?
According to data provider Markit’s website, the Markit iTraxx SovX Western Europe index (an unweighted average of the credit default swap spreads of 15 European, primarily Eurozone, sovereign issuers) closed yesterday, Thursday 14 January, at 73.75 basis points, up 6.28% on the day.
By comparison, Markit’s iTraxx Europe index of 125 investment grade corporate bond issuers trades at 70 basis points.
In other words, lending to a diversified basket of corporate names in Europe is seen as less risky than lending to the governments of many of the countries concerned.
I know that a direct comparison between the two indices is slightly problematic – the definition of a credit event varies slightly when sovereign issuers are involved from the now quite standardized definition of a corporate default.
All the same, this is quite a striking new phenomenon in the credit market. What’s the market saying?
On the one hand, it’s quite possible to see why certain corporate lenders might be seen as safer than many governments. In the UK, for example, Unilever’s (NYSE:UL) 5-year CDS spread, at 31 basis points per annum, is well below the British government’s 81 b.p. Even if the government were to run into financing difficulties as the result of ballooning fiscal deficits, the market is saying, people will still be buying teabags, toothpaste and washing powder, helping Unilever to service its debts.
On the other hand, there seems something quite problematic about corporate credit spreads trading below those of sovereign issuers.
It was, after all, massive and hugely expensive government intervention in late 2008 and early 2009 that underpinned credit and equity markets during a period of blind panic, setting the stage for the remarkable rally in corporate bonds and equities during the second, third and fourth quarters of last year.
Governments performed their lender of last resort function, as they saw it, stabilising markets at least temporarily. But if the creditworthiness of the lenders of last resort is now being questioned, shouldn’t investors also start to wonder whether corporate credits are as safe as they had previously assumed?
In other words, shouldn’t sovereign credit spreads act as some kind of floor for those of corporates? This must apply particularly to the financial sector, given that so many banks have depended on public money for their continuing existence. But there are plenty of other areas of the economy that have benefited from government money over the last 18 months, either directly (carmakers) or indirectly (many others).
And, ultimately, if governments really get into trouble and risk default, they will surely ratchet up tax rates on all economic actors, private and corporate, jeopardizing the financial health of the latter while trying to rescue themselves. This trend in fact seems well under way in many countries.
The recent up-trend in sovereign risk indices (see the Government Risk Index of Credit Derivatives Research in the above chart) should therefore be seen as a potential warning of the end of the corporate credit and equity market rallies, and merits close attention.