One Way to Play a Sovereign Debt Crisis
Soroush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In traditional financial literature, sovereign securities – i.e. government bonds – are considered to be virtually risk-free. Bonds come in many shapes and sizes (in case you need a refresher course in these types of investments, continue reading here). Now, sovereign securities are considered to be risk-free because: 1) compared to corporations, governments have the legal power to generate revenues through taxation; 2) many also have the ability to print money; and 3) sovereign default rates have historically been below those of corporate debtors.
While sovereigns do have absolute authority over revenue-generation methods, an ongoing Eurozone crisis has highlighted how a lack of proper oversight can degrade a country’s fiscal health. In 2012, a host of traditionally airtight nations have seen their reputations slide, as ratings agencies like Moody’s and Standard & Poor’s have downgraded Italy, Spain, France, and five other Euro compatriots. Interestingly, these downgrades can help ardent investors profit, using a concept known as an Ultimate Compression Trade (UCT); we promise it’s as herculean as it sounds.
Broadly speaking, a UCT occurs when a corporation’s debt trades at a lesser credit premium than its respective sovereign or more technically, the credit default swap (CDS) spread for that particular corporation becomes negative. For those who haven’t take Finance 101 in a few years, the credit premium is the difference between a bond’s interest rate and the risk-free interest rate, while credit default swaps are essentially insurance against debt default. Almost always, corporate debt is viewed as a riskier investment than sovereign debt, which would mean that a corporation’s credit premium and CDS rates should be higher. When a corporation denominates its assets in the currency of its respective sovereign, it is also exposed to any risk of currency depreciation, furthering this argument.
Now, the proponents of UCT theory argue that even though a corporation’s balance sheet may contain depreciated assets, it may be able to manage these assets to a better degree than its respective government, hence the possibility that interest rates on corporate debt could exist below that of sovereign debt. While this phenomenon had historically been confined to countries with weak credit ratings, recent economic data points to a greater percentage of companies exhibiting UCT. Using data from the Markit iTraxx indices, which use CDS rates to catalog the credit worthiness of large-cap companies, we can track which companies have a risk premium below that of their government. The table below details this percentage over the past year of market activity.
In the United States, companies like Johnson & Johnson and Microsoft have better risk premiums than the U.S. Treasury, though these are far and few between, and most are titans of their respective industries. In Spain, however, almost every large-cap company is viewed as a safer bet by markets than government debt, where the interest rate on a 10-Year bond has risen by nearly 200 basis points – that’s two percentage points – in the past three months. Intuitively speaking, we can use UCT as a way to measure where investors can feel the safest about sticking their money.
Looking at Spain and Japan – two markets in which capital is heavily favoring corporate bonds – we can say that the sentiment surrounding corporate debt is heavily bullish. Those looking to have a hand in this upswing can invest in theiShares Euro Covered Bond Fund (LSE: ICOV) or the iShares Euro Corporate Bond Fund (LSE: IBCX), both of which have risen almost 4 percent year to date. The former holds a greater number of AAA or AA rated bonds due to the fact that they are "covered," though IBCX still holds predominantly investment grade assets.
While there are no Japan-specific corporate bond ETFs tradable this side of the Pacific, investors can check out the PowerShares International Corporate Bond Fund (NYSEMKT: IBND) or the Barclays Capital International Corporate Bond Fund (NYSEMKT: PICB), though both do not offer a very focused investment approach. Instead, a decent way to play this may be to look at the other side of the coin, at Japanese government securities, which look to be bearish. An inversed option like the PowerShares DB Inverse Jap Gov Bond ETN (NYSEMKT: JGBS) may be a good bet, though novice investors should stay away from the fund’s ‘3X’ version. Going forward, investors would be wise to continually monitor the interest rates on Japanese and Eurozone corporate debt, as many of these markets’ most sound companies are actually exhibiting UCT – lower borrowing costs than their respective governments. To stay up-to-date on this situation, check back at WealthLift Insider in the coming weeks.
This article is written by Hasnain Yousaf and edited by Jake Mann. They don't own shares in any of the companies mentioned above.