A Paradigm Shift On The Road To Safety

Includes: BND, TLO, TLT
by: Dorsey Wright Money Management

Treasury debt has always been considered the safest debt you can buy. The bond market convention is to price debt in basis points over Treasurys. Even though Treasury yields are obscenely low, the last go-round saw a few corporates trade through Treasurys to a lower yield.

Now, it appears that market participants think the default risk on Treasurys is higher than the default risk on some high grade corporate debt. Clusterstock reported on Gillian Tett’s original article in the Financial Times:

Tett argues that multinational “American” companies may really be better bets than the sovereign government of the U.S. for two reasons: overseas diversification and transparency.

While CDS are not always the most accurate methods of assessing a credit bet, the cost of insuring U.S. debt exceeds the cost of insuring the debt of 70 different companies based in the U.S. Not to mention the fact that S&P’s has maintained the AAA-ratings of Automatic Data Processing, ExxonMobil, Johnson & Johnson, and Microsoft.

First of all these companies are more easily able to hedge their bets against economic downturn because they can transfer their funds overseas. Second, their finances are far more transparent and less politically volatile (ehem, debt ceiling) than those of the U.S.

So not only are the companies safer than the Treasury—there might even be a good reason for it. That’s quite a paradigm shift. Theoretically this shouldn’t happen. The US government has the ability to levy taxes to pay its debt; corporations are dependent on the goodwill of their customers.

Fixed income valuation models predicated on pricing over Treasurys would conclude the Treasurys are drastically undervalued relative to corporates—but what if they’re not? What if this turns out to become a common condition, as it has in several European countries?

Counting on things to revert to historical relationships is dangerous. You could be right, or spectacularly wrong if a paradigm shift is underway. Systematic use of relative strength seems safer to me because it does not make any assumptions about relationships between and among financial instruments.