Risk Analysis: Corporate bonds vs. Government bonds | Are Treasury bonds actually not risk-free? | Is the government's power of taxation for debt service a realistic guarantee against default?
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Top government bonds issued by developed nations, such as the U.S., are considered by the majority of economists and financial analysts as being risk-free. The fundamental reasons provided are that top, developed countries, such as the U.S., Canada, England, Norway, Singapore, & Finland (not an exhaustive list – as of 2021), for example, have never defaulted, and these entities being nation-states, have the power to tax legal personalities domiciled in their jurisdictions.
While it is also stated that these instruments are backed by 'the "full faith and credit" of the national government and thus by that government's ability to raise tax revenues and print money,' in all practicality, the power to tax legal personalities/entities is the ultimate financial guarantee backing these debt obligations.
Corporations, on the other hand, being reliant on the business they conduct to remain a going concern, it is argued, have a higher inherent risk, compared to sovereign nations. Corporations have to manage competitive and economic pressures, manage supplies and distribution channels, etc., thus, all in all, the risk firms are exposed to is considered much higher than what nations are exposed to, and therefore, corporate-issued bonds, broadly, are perceived to be somewhat risker by the market in general.
But is this generic assumption rational and valid? This report presents an alternative prism of view, through which we can see that government-issued debt, especially now, maybe riskier than top-rated corporate debt secured by collateral (first lien debt).
While nations also have the ability to repay such obligations with the cash flows from the projects they invest in through such borrowings, in recent years, significant increases in sovereign debt have been due to cyclical, and idiosyncratic causes such as recessions, depressions, external economic shocks etc., and not due to exceptional credit demand for funding new development projects that would yield positive returns. No developed nation is building Hoover dam like projects anymore . . .
Details from budget spending in recent years also support this view that new revenue-generating government projects have declined; thus, the majority of debt of developed countries, debatably, is backed by the government's power of taxation.
Practitioners view highly rated debt issued by corporations as essentially equivalent to government-issued debt; however, this report presents arguments that, realistically, the former may be less risky than the latter.
Is government-issued debt really secure? Why is sovereign debt actually risky?
Let's tackle the most commonly stated argument first (example of the U.S. is used): 'The government has never in its history defaulted on its debt . . . while the country has experienced many catastrophic episodes, such as wars, natural disasters, financial crises, etc., but default never occurred."
While this point may be appealing to a novice, it is not logically grounded. Just because something hasn't happened before, doesn't mean it can't happen in the future. The countries that default for the first time also have no history of such occurrences in the past.
Other relevant points that must be added here are that the U.S. debt-to-GDP ratio has never been over 120 in a period of relative peace – a figure crossed in Q2 of 2020. Total public debt in America increased 68 times in the last five decades, growing at a rate of 8.84% p.a. (geometric mean) (USDT, 2021). U.S. GDP in the same period grew at a rate of 6.12% p.a. (geometric mean) (W.B., 2021); this discrepancy in the two rates has not risen to significance due to a decline in interest rates in recent periods.
Governments can sustainably borrow long term; however, a rising Debt-to-GDP (D/Y), detached of cyclical adjustments–i.e., a considerable lowering of debt during the peak of the business cycle and a rise during the troughs—makes debt unsustainable in the long-term.
D/Y changes due to three main factors:
1. D/Y further rises as interest on the existing amount is added to the debt, further increasing the D/Y; rate of interest may also increase due to increased debt, thus, all in all, a higher growth of the denominator.
2. It falls because of the growth of the GDP. i.e., higher growth of the numerator.
3. Debt also changes due to the size of the primary deficit relative to the GDP.
If the growth rate of the interest on debt, denoted as r, is higher than the growth rate of the GDP, denoted as g, and the country continues to run large primary deficits, then the debt cannot be considered as sustainable long-term. Deductively, we can state that countries can run a consistent deficit only if the growth rate of national productivity is higher relative to the interest rate of debt, or if the government can run persistent primary surpluses to offset previous deficits.
In the present condition, however, the U.S. and other developed nations being mature economies, aren't likely to experience a long-term growth rate of more than 2.5%. However, the ballooning debt, coupled with a decreased demand of sovereign bonds internationally, due to over-issuance, etc., and increased inflation expectations due to the post-2020 increase in the money supply, may end the long-term rally in government bonds and increase the rate of interest on government-issued debt beyond sustainable levels. If that happens, the likelihood of default will increase considerably.
The vast majority of borrowed spending in recent years primarily used to support the economy or the government, rather than being invested in projects that would increase the governments' power to repay the debt, i.e., meeting the intertemporal budget constraint ("the current stock of debt should equal the present value of future primary surpluses. If that is not true, default will occur at some point"), should also ring alarm bells (Miles et al., 2012; Attanasio & Weber, 2010).
The fallacy of the taxation power of governments making sovereign debt risk-free
The ultimate guarantee of government debt is supposed to be the power of taxation. As taxes can be increased, if need be, such borrowings, especially by countries that have never defaulted before, are argued to be 'risk-free, in essence.'
But is this credit security mechanism, or financial guarantee underlying the debt obligation, realistic and practical?
Let's examine a scenario:
Let's assume that due to monetary gymnastics of recent time, most notably quantitative easing, and the unprecedented increase in the money supply during the 2020-2021 crisis period, there is a rise in secular inflation, due to which, interest rates on the sovereign bonds increases considerably. Demand for debt by national and international agents drops as they expect a crash in bond prices. If the total debt figure for the country is over $30 trillion, and the total effective interest rate goes up to, say, 5%, the treasury would have to pay 1.5 trillion p.a. in interest payments, an amount equivalent to 23% of the total government spending in 2020 (CBO, 2021). With limited further refinancing options, would the treasury and other arms of the state be able to exercise their 'power of taxation' to service the debt?
"When troubles come, they come not single spies but in battalions." (Claudius, Hamlet Act IV, Scene V).
We must understand that if such a situation arises, i.e., if the servicing of the national debt in a developed country is in a precarious position, the likely hood is that the government & the economy would already be in a crisis. In such a situation, when the economy is on the precipice of a financial disaster, increases in taxes by the government for debt servicing is highly unlikely, as doing so would put further pressures on citizens and businesses, the impact being contractionary, in an environment when expansionary fiscal and monetary policy would be a necessity to avert a disaster. Thus, an increase in taxes in such an environment is unrealistic.
This viewpoint aids in understanding that the unsophisticated guarantee of governments of their 'power of taxation' shouldn't be accepted as a reasonable guarantee against default, as in a scenario when default is likely, they may not be in a position to increase taxes for debt servicing.
In all major disasters in recent history, expansionary fiscal policy has been used as a tool to stimulate the economy. Recently, in the 2020-2021 crisis period, we witnessed unprecedented fiscal and monetary actions as well. Arguably, such Keynesian tools are the only cards regimes hold in economic crises, and the thinking that they would do the opposite in a crisis for servicing debt, substantial portions of which are held by foreign countries that, more and more, are seen as adversaries, is incredibly unrealistic—some would say imbecilic.
It is also worth noting that the U.S. & other developed nations, in recent times, have not taken actions to demonstrate a credible commitment regarding debt repayment at a specific stage in the future. We haven't witnessed any considerable developments in terms of a sinking fund arrangement gaining more attention or a credible modern financial strategy devised to repay the debt (Sylla & Wilson,1999). One cannot help but notice that the prevalent view in Washington, London, Ottawa, etc., is that this is a future problem that those making the decisions in the present wouldn't have to confront.
Therefore, a vague financial guarantee that is impractical, as explained above, by actors that, arguably, perceive themselves to be detached from the consequences of their borrowings—on behalf of their constituents—shouldn't be considered risk-free. Doing so may cost 'many a central bank' unbearable losses in the future.
Why is highly rated corporate debt actually less risky than sovereign debt?
Corporate debt that is secured by a physical asset, such as land, real estate, and even to some degree, aircraft, railroad cars, shipping containers, or oil rigs (Equipment trust certificates) (broadly, first lien debt), may actually be less risky than the sovereign bonds, considered as 'risk-free.'
Businesses, as explained in the first part of this report, are argued to carry an inherent risk, being dependent on markets and economic factors, etc. While this point is accurate, broadly, the subject of our inquiry is investment/default risk (credit risk), more precisely, the risk that an investor may lose the initial amount/value, the outlay, invested in the bond.
Why are corporate bonds less risky?
Bonds that are secured by collateral, collateral that is likely to retain its value, or fluctuate in a reasonable range, through this alternative view we see, ensure that the principal is backed by a tangible asset, not just a guarantee of good faith, or a mechanism that may not be implementable is a crisis (with is dissected in the previous section).
For example, let's assume that a corporation, ABC inc., issues a five-year bond with a 10% coupon rate, the backing or credit guarantee of which is provided through a pledged plot of land that is in a prime location and, thus, valuable (first lien debt). Should we consider such a bond to be a safer investment than a sovereign bond? Yes, we should.
In a catastrophic economic/financial episode or systemic crisis, as explained above, the government's guarantees against default may not work (as explained earlier), and in the worst-case scenario, there is a risk that such default by a national treasury may mean that the principal of the investors is not paid back, and an outright capital loss occurs for the investors. However, if a corporation defaults on its loan, but the loan is secured through collateral that is likely to retain its value, or, say, 70% of its value, there would still be a penal sum recoverable, the principal amount invested wouldn't be lost entirely; this may not be an option available in the case of default by a sovereign state.
(As per Moody’s study on recovery rates of nonfinancial North American companies, while the amount recovered in case of bankruptcies varies across firms, business sector, and credit cycle, overall, the study found the average recovery rate of senior secured bond from 1987-2017 to be about 60%, i.e., per $1 invested, creditors recovered about $0.6, on average, from defaulted companies. On the other hand, there may be no recoverable amount in case of a sovereign default. Standard & Poor's examination of "one-year global corporate default rates by rating category for the 20-year period from 1998 to 2017," nonetheless, revealed that 0% of AAA rated constituents in the time series analyzed defaulted.)
Thus, in terms of guarantees regarding a recoverable penal sum, in the case of default, the corporate bonds offer tangible collateral that should retain value, in whatever prevalent medium of exchange that the investors most value.
Furthermore, in many cases, firms also provide further credit enhancements that reduce the risk for highly-rated debt. Notable example:
· Overcollateralization, which refers to the process of posting more collateral than is needed to obtain or secure financing, thus, protecting the investment from market fluctuations of the price of the collateral or securing investors against the degradation/depreciation/devaluation of collateral which may be especially important in the case of Equipment trust certificates: bonds secured by certain types of equipment or physical assets, such as aircraft, cars, containers, oil rigs, railroad, shipping, etc.
· Reserve funds/accounts, which is a cash reserve fund, and an excess spread account. A reserve fund is a reserve of excess cash that can be used to absorb losses, and an excess spread account is an account to deposit excess funds from a project, unit, division, etc., that are left over after paying out the interest to bondholders.
· Security bonds/letter of credit: security bonds are bank guarantees that recompense the bondholders in case of losses; a letter of credit is a guarantee provided by a financial institution to reimburse the bondholder in case of losses or shortfalls of cash flow from the assets backing the issue.
· Cash collateral account is an amount borrowed by the issuer to purchase highly rated short-term commercial paper, etc., to provide a credit enhancement for the issue.
(Not an exhaustive list. Adopted from: FIXED INCOME AND DERIVATIVES, CFA Institute, ISBN 978-1-946442-80-2)
Hence, a corporate bond, we see, has tangible value backing it, with sovereign debt only has a verbal guarantee that may not be realistic.
(Defaulted corporate bonds often continue to be traded by brokers & investors, as per the assessment that in a liquidation or the reorganization of the bankrupt company, there would be some recoverable value gained. This is unlikely to be the case for bonds issued by sovereigns, as there wouldn’t be a tangible asset available, the proceeds of which can be distributed among creditors.)
Another point that must be noted here is that large corporations usually have business operations in multiple countries and thus may not be exposed to cyclical risk in a specific economy or region.
For example, developing countries, such as China, experienced a GDP growth rate that was significantly higher than the Western Economies (over 9% for China during the 2008-2009 financial crisis period) (WB, 2021); firms that have operations in a wide variety of markets, such as Procter & Gamble, Unilever, The Coca-Cola Company, Microsoft, etc., due to geographically diversified operations, may not be severely impacted by a severe crisis in just one market, say, Canada, UK, or Belgium. A specific government, on the other hand, may default on its debt due to an internal crisis.
Those convinced by the above-presented points may still have a concern that in the case of court-directed reorganization, for example, in chapter 11 large reorganization, the priority or the claim over the collateral might not be upheld; i.e., investor(s) believing that they have a priority or claim over an asset (collateral), and thus, the funds they provided as a loan are safe, may have a fallacious sense of security, as a court-directed reorganization may change the terms & priority/claim over the assets used as collateral.
While this may be considered a valid concern for firms with corporate credit rating below AAA (S&P), it is not a risk vector of concern for highly established, AAA rated, large multinational firms: the success rate of chapter 11 filings is observed to be less than 10%; also, the average yearly filing rate of chapter 11, historically, has been under 1%, with a recent exception being the 2020 crisis period; however, this rate, even in 2020, was close to 1%, standing at 1.34% (U.S. Courts, 2021).
Realistically, therefore, large multinational firms that have diverse & reliable sources of cash inflows cannot, pragmatically, be considered as 'likely to file for chapter 11.' AAA rated corporations, practically, have a >1% probability of filing for this type of bankruptcy as per the historical data, and coupled with the fact that there is a low success rate & a low filing rate for this type of bankruptcy, it is ignored by practitioners for firms with the characteristics described here.
The likelihood of this risk materializing for the type of firms described here is less than 0.5%, as per the data. While bankruptcies may rise in a future financial crisis, for the type of firms described here, the rate of chapter 11 filings is unlikely to rise considerably above 1%.
There is still a procedure & mechanism involved with chapter 11 bankruptcy that a debtor (firms) must follow, which logically is far superior a mitigating mechanism than a guarantee of a government which, due to practical limitations, may not actually be implementable.
For the skeptics or idealists that still may not be convinced, a further point might help:
Some may argue that the national debt, especially in the U.S., Canada, & U.K., is 'as secure a debt as it gets' due to the solemn commitment provided by the government, and as it is a national debt, the responsibility of repayment, borne by individual citizens, would always be honored. It may also be added that as per the commitment, the U.S. would be obliged to honor the commitment by raising taxes on legal personalities to service the debt and that businesses have a higher risk compared to the government as they are reliant on a number of factors for survival, yet survival of a sovereign nation may not be in risk.
If we accept this line of reasoning, for argument sake, we would have to accept a further reality: taxes, logically, are raised from income and profits, income and profits are generated through productivity produced by economic agents, the taxes, thus, can only realistically be raised if there is positive productivity, and productivity is dependent on economic agents, the biggest portion of which is generated by businesses (individuals self-employed are also included in the definition of businesses here).
Deductively, therefore, we can see that the governments' commitment to service debt through taxes, if need be, is dependent on economic productivity, and if economic productivity is largely dependent on businesses, the guarantee of the sovereign debt, deductively, we must accept, is backed by the businesses in the economy as well.
Holistically, we can hence see that guarantee of the governments (of taxation) is backed by businesses, and thus, government-issued bonds, theoretically, can be seen as debt securitized by business activity in the economy, and therefore, can be seen as being one tranche above the lowest tranche, which is the dividend provided to shareholders by businesses. As profits would only be available when all interest payments on the debt of businesses are made, we can see that the guarantee, and hence the nature of such debt, make it subordinate to corporate debt, which must be paid first, and thus, should be considered a senior tranche.
A diversified portfolio of highly-rated corporate debt that is considerably secured by tangible assets that are likely to retain their value, to the degree that eliminates investment/default risk for bondholders, should be considered less risky than debt issued by governments, as sovereign debt, as explained in the previous paragraph is also, in all practicality, protected by business activity in the economy, but the protection of debt by the government, as explained above, is inferior to that of debt backed by tangible assets.
Debt enhancements and international diversification of large businesses are additional factors that favor corporation-issued debt. Over time, due to these factors, we may see a significant divergence between the yields of the two types of debt discussed in this report. A significant divergence in the interest rate of the two, i.e., an increase in the interest rate of sovereign bonds, without a corresponding increase in the interest rate of secured corporate bonds, in certain jurisdictions, may be an indicator by the market that a sovereign default or significant difficulty in debt servicing by the treasury may be experienced.
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Attanasio, O. P., & Weber, G. (2010). Consumption and saving: models of intertemporal allocation and their implications for public policy. Journal of Economic Literature, 48(3), 693-751.
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