After weeks of waiting for an agreement on raising the debt ceiling, many investors are now wondering which direction the economy and financial markets will head. For many, concerns over higher interest rates will color their investment decision-making. So who better to turn to for insights on what may lie ahead than Banyan Partners’ Director of Fixed Income Steve Chapman?

As Steve likes to point out, investors would do well to recognize that in the aftermath of the financial crisis, the traditional relationship between government and corporate bonds has been turned upside down. As Steve puts it, “The Fed cleaned up the private sector’s financial problems during the crisis. Now corporate balance sheets are squeaky clean, while our public finances are a mess.”

As we’ve witnessed over the past couple years, credit ratings on the sovereign government debt of many nations has been declining steadily.

In previous issues of the Banyan Market Letter, we’ve detailed the ongoing credit crisis in Europe. And you couldn’t turn on the TV in recent weeks without constantly hearing that America’s sterling triple-A credit rating was under threat of imminent downgrade.

If you are a fixed income investor, this situation could have significant implications for your bond portfolio.

In fact, you may need to completely rethink your income strategy in today’s changing markets because, ever since the 2008 credit crisis, the creditworthiness of government versus corporate debt appears to be trading places.

Bond Investing 1.0 … The Way Things Used to Be

Historically, investors assumed that sovereign government bonds carried lower credit risk than other bonds, especially corporate debt, because a country in good credit standing would never default on its obligations.

The trade-off for investing in “riskless” government bonds was that you earned a lower rate of interest.

On the other hand, corporate bonds carried more risk, according to investors, because individual companies can default on bond payments and/or restructure obligations when times are tough.

Investors demanded a higher interest rate for owning corporate bonds, because they assumed a greater risk of credit downgrades or defaults.

Because of this historic perception of risk-free government bonds, the market for US Treasury securities grew in size to more than $14 trillion. It is by far the largest market in the world. US Treasury bonds are held far and wide by foreign governments, millions of individuals, thousands of American banks and insurance companies, corporations and pension plans.¹

But are AAA-rated Treasury bonds really the risk-free gold standard that fixed income investors believe them to be? In our opinion, not anymore.

Who Bails Out the Lender of Last Resort?

As Steve explains, many large US corporations have been deleveraging balance sheets in recent years, paying down debt and raising cash. Some of this was forced deleveraging during the last recession when companies like Lehman Brothers went bust.

In several cases, however, the US government stepped in to assume the debt obligations of private corporations and transferred that debt to Uncle Sam’s balance sheet. This was the case for General Motors, Fannie Mae and Freddie Mac, for example.

Of course, the US government also took on additional debt to pay for bank bailouts, quantitative easing (2 rounds), and assorted “stimulus spending,” adding to Uncle Sam’s balance sheet burdens.

By contrast, Corporate America, like many individual American consumers, focused on paying off debts and raising cash.

The result: Many US corporate balance sheets are in excellent shape today. They are flush with cash, sitting on a record level of $2 trillion in cash and short-term investments.²

The US high-yield corporate default rate fell to just 1.3 percent at the end of 2010, well below its long-term average. This is quite an improvement from the peak default rate of 13.7 percent in 2009, indicating a vastly diminished risk of corporate credit stress.³

At the same time, the perceived default risk of the US government (not to mention many European governments) has been moving in the opposite direction. Why? Because the lender of last resort — Uncle Sam — is staggering under a huge pile of debt … and nobody is standing by to bail us out.

Bond Investing 2.0 … Today’s Reversed Reality

Fixed income markets and many investors are quickly catching on to this reversal of fortune in perceived credit risk between US companies and the US government.

In the last 12 months, a growing number of US public companies are perceived by the market to have a lower risk of default on their debts than the US government.

It’s easy to compare relative default risks among companies or countries by looking at the market for credit default swaps (CDS). A CDS is a kind of insurance policy that pays off in the event a company or country defaults on its debt … otherwise known as a “credit event.”

Needless to say, the risk of a credit event has been rising sharply in Europe as finance ministers struggle to come up with a credible bailout plan for over-indebted PIIGS. Likewise, as the debt ceiling circus played on in Washington over the past several months, CDS prices (known as spreads) on US government debt have been rising too.

As of yesterday, the cost to insure against a US debt default over the next five years was 47.6 basis points, according to CDS spread data from Bloomberg.⁴

By comparison, the list of high-quality US corporations that are judged to be a better credit risk than Uncle Sam (with lower CDS spreads) is increasing by the day.

In fact, 53 investment-grade US corporations — over 10 percent of the S&P 500 Index — have CDS prices LOWER than the US government’s! That number is up from ZERO just one year ago.⁵

So while the media is buzzing about a potential US credit rating downgrade, many investors deem a select number of high-quality US corporate bonds already have a lower default risk than US Treasury debt!

And it’s not just in the US … in Europe 100 percent of high-quality corporations in Spain, Portugal and even Greece have lower CDS spreads than their respective governments.⁶

In other words, you’re better off investing in any high-grade Spanish corporate bond than in Spain’s sovereign debt.

Corporate Credit May Be a Better Bet than
Risk-Free Treasuries

It’s clear to see why investor perceptions about bond risk have swapped places. US corporations generally have better balance sheet strength, lower debt levels, and in many cases, more cash than the US Treasury.

Taking a closer look at high-quality US companies that are considered a better credit risk than Uncle Sam, we find several companies on the Banyan Buy List.

These include health care giant Abbott Laboratories (NYSE: ABT), industrial conglomerate United Technologies (NYSE: UTX) and, from the energy sector, ConocoPhillips (NYSE: COP), among others.

This leads us back to why you may want to reconsider your own fixed income strategy … and take another look at what’s in your bond portfolio.

Banyan’s Chief Investment Officer Michael Blackmon has long advocated high-quality US corporate bonds of short duration (5 years or less) for our fixed income clients, rather than Treasury bonds of similar maturity.

Steve likewise favors corporate credits, including both investment grade and high-yield securities, for the fixed income portfolios he manages.

Not only can you obtain a higher yield than on comparable US Treasury securities, but in some cases (ABT, UTX, COP), you’re also investing in corporate bonds that are considered a lower credit risk than Treasuries right now.

In other words, high-quality corporate bonds look like a better bet than so called risk-free US Treasuries!

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

P.S. To learn more about the custom income-producing strategies we use at Banyan Partners, get a copy of our special report: The Banyan Guide to Bond Surrogates.

---

Banyan Partners and the advisory accounts that we manage may have positions in the securities mentioned in this report and may purchase or sell such securities without notice. This newsletter is not a complete analysis of every material fact with respect to any company, industry or security mentioned in this report.

The investments discussed in this newsletter may not be appropriate for all investors and past performance is no guarantee of future results.  Investors must make their own decisions based on their specific investment objectives, risk tolerance, and financial circumstances. This report is solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.

Corporate and government bonds are very similar but have key differences.  Investors should fully evaluate the tax treatment of various bond types as well as credit risk, liquidity risk, inflation risk and interest rate risk prior to investing.

---

¹ Washington Post: Could a US debt downgrade trigger a financial crisis?, 7/29/11
² Bloomberg Businessweek, 8/2/11
³ Fitch: US High Yield 2011 Default Rate Projected at 1.5% - 2%, 2/1/11
⁴ Bloomberg market data, 8/2/11
⁵ Bloomberg market data, 8/2/11
⁶ JP Morgan: US Equity Strategy, 7/21/11