Clients seeking safe havens for their investments are correct to question if government bonds provide it. Although markets have used government debt as the floor for other debt, the new reality is that global companies are seen by the market as being almost as safe or, in some cases, safer than what used to be the safest bet in the world — U.S. treasuries. Now, it’s time to look for a new, riskless place to park money.
“I’m beginning to think,” says Caroline Nalbantoglu, president of CNal Financial Planning Inc. in Montreal, “that top-level corporate bonds subject to due diligence are at least as good a bet for holding their value and return of principal as the bonds of nations with shaky finances.”
The lustre associated with U.S. Treasury debt got tarnished during the financial crisis. And although the idea of a U.S. default may seem preposterous in retrospect, notes Edward Jong, head of fixed-income and vice president at TriDelta Investment Counsel Inc. in Toronto, a faction in the U.S. Congress did hold U.S. sovereign debt hostage this year, imperilling the U.S.’s status as the world’s banker and manufacturer of the world’s currency reserves.
Now, in this post-financial crisis environment, best-of-breed corporate bonds look less likely to default. Among U.S.-based companies, Microsoft Corp., Automatic Data Processing Inc., Johnson & Johnson and Exxon Mobil Corp. have AAA ratings from New York-based Moody’s Investors Service Inc. No credit-rating agency predicts these top corporations will default or that their senior management will refuse to make interest payments or refund the principal on their bonds.
Two days after the U.S. Con-gress’s Oct. 16 resolution, the Exxon Mobil 5.5% issue due June 18, 2018, was priced at $117.50 to yield 1.57% to maturity. That’s a 25-basis-point (bps) spread over five-year U.S. treasuries, which is very tight compared with the usual spread of 80 to 100 bps.
“The full faith and credibility of the U.S. have been damaged,” says Jack Ablin, executive vice president and chief investment officer with BMO Harris Private Bank in Chicago. The crisis in Congress raised the issue of the U.S.’s willingness to pay its debts, he adds: “It has been trusted to pay up, but the roller-coaster ride between default and honouring debt raises the question of the intentions of the U.S.”
The degradation of U.S. treasury debt is not without precedent. During the Great Depression in the 1930s, U.S. corporate bonds traded at yields below those of bonds issued by the U.S. Treasury. Blue-chip companies were making money even though the country was running a deficit. U.S. federal tax revenue was below what the government was spending. Bond buyers were willing to swap their government debt for corporate debt.
Today, the problem is not lagging tax revenue but political baggage that has cast doubt on the willingness of the U.S. government to pay up on time. In turn, that impairs the position of U.S. treasury obligations as the global reference for all other government and corporate debt. The alternative is pricing debt against top-grade corporate bonds from the U.S. and other nations.
“It wouldn’t be confusing to have the world’s corporate debt markets priced off a basket of global AAA [rated] bonds,” Jong says. “As long as they’re in one currency, there would be one yield curve for the group and, therefore, you could measure spreads and determine if a bond were trading above or below the relevant curve.”
The world’s debt markets also would benefit from a new currency upon which the yields of both sovereign and corporate bonds would be based. That currency would have its own yield curve.
The government of China, which holds massive amounts of U.S. Treasury debt, has called for an alternative world currency. In 2009, Wen Jiabao (then China’s premier) called for a new currency to use for sovereign currency reserves. The new money, suggested Bank of China governor Zhou Xiaochuan in 2012, would be called “special drawing rights” (SDRs) and based on the shares held in the International Monetary Fund by its 185 member nations. The SDRs would be issued by formula, would be immune from political tampering and no longer would allow the U.S., as the world’s central money creator, to export its inflation to the rest of the world.
It could take many years for the world’s central banks and monetary authorities to develop an alternative currency such as the SDRs. In the meantime, you can put your clients into diversified sovereigns and top-grade corporate debt from the U.K., Germany, the Scandinavian countries and the Netherlands. There might be some currency risk, says Camilla Sutton, chief currency strategist with Bank of Nova Scotia, but it’s not much, given the very low spreads between short interest rates in Canada and those of the alternative countries.
You also need not take on the job of shopping for foreign bonds. Several low-cost global bond exchange-traded funds (ETFs) can do the job, such as iShares Aaa-A Rated Corporate Bond ETF and iShares Intermediate Treasury Bond Ex-U.S. ETF, both sponsored by New York-based BlackRock Inc.
That a rump of U.S. Congress was able to hold the U.S. Treasury and the market hostage indicates that it’s time to move to a new standard of supposedly riskless assets. The alternatives in best-of-breed corporate debt or baskets of other governments’ debt are accessible, inexpensive to use and will let your clients sleep well at night. IE