The old textbooks from your college Finance 100 or Intro to Portfolio Theory 201 classes may need to be revised in this new day and age of credit default swaps. The swaps may be blamed for a lot of things but one thing they sure seem to do a good job at is quantifying risk and exposing inconsistencies that may otherwise go unnoticed.
When investors smell danger they traditionally always turn to good old trustworthy government bonds – particularly the American kind. You cannot get a better risk-free asset than one “backed” by the full faith and credit of the United States of America. Or can you? Where students of past were taught of efficient markets (no wonder it was called a hypothesis) and capital asset pricing models (CAPM) that supposedly attributed higher returns commensurate to higher risks, today’s students can find plenty of examples where that may not necessarily appear to be the case.
Case in point is the existence of credit spreads (at least those measured in terms of CDS spreads) that trade inside the credit spread of their home country. People don’t realize that there are some individual companies whose CDS spread is tighter (thus less perceived risk) than USA sovereign CDS. IBM, McDonald’s and Hewlett Packard, for example, all trade between 40 and 45 bps which is tighter than US CDS (currently around 50 bps). Baxter International, Bristol Myers Squibb, Campbell Soup and ConocoPhillips are even tighter than the first group trading just under 40 bps.
For those that are unfamiliar with what these numbers mean, basically what it says is that investors perceive there to be more risk of default or distress in owning a American government bond than in owning a corporate bond issued by companies like McDonald’s, HP, Campbell’s Soup and IBM. How can that be the case if the US government can never go bankrupt while a company can? Well, that is exactly the point – it doesn’t necessarily make sense but that is just the way it is right now. Apparently “investors” think that they can trust guys who buy french fries, computers, chunky soups and servers more than they can trust a collection of printing presses that can literally print money (the next best thing or maybe even better than money growing on trees).
This phenomenon repeats itself in other countries as well. German utility company RWE trades within a few basis points of German sovereign CDS (45 bps). Munich Re and Henkel AG are not far behind hovering around 50 bps. British Petroleum at 50 bps, Compass Group at 55 bps and British American Tobacco at 62 bps all trade much tighter than UK CDS at around 90 bps. Even in Asia, Korea Electric Power trades around 85 bps while Korean Sovereign CDS trades around 115 bps.
True in this day and age of globalization, large debt-issuing companies rarely make all their money in just one country so maybe comparing a company’s CDS spread with just one country is a bit off-the-mark but even then with sovereign CDS spreads worldwide rising, how big a share of their revenues and risks (accounting tricks aside) can any of these corporate giants really attribute to Norway (whose CDS has not really increased that much and is the tightest CDS spread of all major sovereign nations at around 20 bps) in order to mathematically adhere to traditional or theoretical pricing methods like the CAPM?
Of course, professors can always retort to the keener who points these exceptions out that the definition of risk-free rate may not necessarily be the American treasury rates (this is theory after all, that’s why it is called the risk-free rate and not the USA rate – perhaps there is really no such thing as a risk-free rate in the real-world and we are kidding ourselves into thinking that we can ever really find one to put into our real-world financial models in which case CAPM still probably holds true in theory, even if it is effectively rendered useless in practice for lack of an actual rate to use, and everyone else that can think of another exception can go take a [rate] hike. Class dismissed)
Another angle to the phenomenon of misplaced credit spreads is that fact that big-branded companies that represent “distressed” or “peripheral” sovereign countries in name or in geography are also experiencing noticeable increases in their own credit spreads possibly as investors are using them as a proxy for sovereign CDS. A recent Financial Times report highlights the outperformance of Deutsche Telecom relative to Portugal Telecom, RWE relative to EDP and Commerzbank relative to National Bank of Greece while also noting that some companies from affected countries with significant emerging markets operations have fared a lot better such as Telfonica and Coca-Cola Hellenic Bottling.
Disclosure: long all stocks mentioned