Mispriced Credit Risk

Posted on July 16th, 2015 by David Laidlaw

Most investors who own fixed-income securities assume that interest will be paid over the life of their bonds and the principal returned when the bonds reach maturity. However, there is always the risk that these payments will not be made as expected. We do not believe the risks associated with default are being priced appropriately throughout the bond market. Investors are not getting compensated for these risks even though some prominent credits are in default or close to default now.

Greece has required multiple bailouts from the European Central Bank (ECB) to meet the country’s financing needs and repay the funds it has borrowed. As discussed ad nauseum in the financial media, the current government has not been able to reach an agreement with Europe or the International Monetary Fund (IMF) regarding terms for continued financial support. Greece owed a $1.7 billion payment to the IMF on June 30th, but did not make the payment. Europe wants Greece to reduce its pension payments and enact reforms to make its economy more productive, such as lowering the retirement age; however, the current Syriza government and the Greek people rejected these measures decisively in a national referendum.

Greece’s bonds fully reflect the dangers of default. As of July 2nd, a 4-year bond with a 5% coupon only sells for $57 which implies a yield to maturity of 24.8% if all interest and principal is paid. However, Italy’s bonds do not seem to reflect the credit risk of Italy defaulting. An Italian 4-year bond only yields 0.94%. Italy is not Greece, but the country still has significant fiscal problems. Italy’s debt is over 1.3 times larger than the value of its gross domestic product. The country is running a modest 3% budget deficit, but faces daunting demographic challenges. Given these numbers, how is anyone content with investment returns of less than 1% for these intermediate term bonds?

As noted above, a similar debt problem is blossoming much closer to home. Puerto Rico’s governor announced recently that the government will not be able to pay its debt as its spending continues to expand. Puerto Rico is a commonwealth of the United States and its bonds are tax-exempt for US citizens. Therefore, many US citizens own these bonds and are now facing substantial losses. A typical Puerto Rican-backed bond due in 4 years yields about 23%.

However, a bond of comparable maturity issued by Illinois for the same period yields an unimpressive 3.65%. Similar, to Puerto Rico and Greece, Illinois has a very large pension liability. While its tax base is much healthier, mobile businesses and successful individuals are leaving the state for lower tax alternatives.

The graph on the first page shows that the yields of bonds with weak credits such as Italy and Illinois are much closer to comparable entities with very strong credits such as Germany and Virginia than they are to troubled credits such as Greece and Puerto Rico. A rational investor should demand higher returns from a weak borrower since the downside is so large.

If a company defaults on its bonds, the ownership of the company transfers to the bondholders who are able to dispose of the assets to get some level of satisfaction of the debt. However, if a government defaults, the bondholder is entitled to …. nothing. Given the dire consequences of default and the shaky financial health of many government issuers, we believe it does not make sense to purchase risky bonds for low yields.