Credit ratings are becoming irrelevant in a bond market where investors still perceive AAA companies from Johnson & Johnson (JNJ) to Microsoft Corp. (MSFT) to be a higher risk than recently downgraded U.S. Treasuries.
The extra yield investors demand to own bonds issued by top-rated companies versus Treasuries reached 0.81 percentage point, the most since July 2010, after S&P cut the U.S. one level to AA+ on Aug. 5, according to Bank of America Merrill Lynch index data. A wider spread indicates investors perceive the higher-rated companies to be a greater credit risk.
S&P, which along with Moody’s Investors Service and Fitch Ratings was blamed by U.S. investigators for fueling the worst financial crisis since the Great Depression by assigning AAA ratings to bonds backed by subprime mortgages, is again muddying the waters for investors attempting to divine the relative creditworthiness of fixed-income securities.
“The Treasury bond is still regarded as the ultimate risk- free security,” Edward Marrinan, the head of macro credit strategy at RBS Securities in Stamford, Connecticut, said in an e-mail. “The U.S. government has taxing and legislative authority over corporations domiciled in this country. In the most extreme of financial circumstances, the U.S. has the ability to print its own currency to honor its debt obligations.”
In cutting the U.S. one step to AA+ on Aug. 5, S&P cited the weakening “effectiveness, stability and predictability of American policymaking and political institutions.”
Moody’s and Fitch affirmed their AAA rankings on Aug. 2, after President Barack Obama and Congress avoided default by agreeing to lift the debt ceiling. Warren Buffett, the world’s most successful investor, said S&P erred and the U.S. should be rated “quadruple-A.”
Demand for U.S. debt was on display yesterday as the Treasury auctioned $24 billion of 10-year notes at a record-low yield of 2.14 percent. The bid-to-cover ratio, a gauge of demand which compares total bids with the amount of securities offered, was 3.22, versus an average of 3.11 at the previous 10 sales and 3.17 at the last auction on July 13. The U.S. will sell $16 billion of 30-year bonds today.
Investors are seeking Treasuries as the economy slows and stocks tumble. The Standard & Poor’s 500 Index has plunged 13.3 percent this month after declining 2.2 percent in July.
“The Treasury is still the highest quality, most liquid, safest asset in the world, as the asset of choice when you’re looking for safety,” said John Donaldson, director of fixed income at Radnor, Pennsylvania-based Haverford Trust Co., which manages $6 billion. While “the current trajectory of spending and deficits is a long-term negative, we would think a negative outlook is more appropriate than a downgrade,” he said in an Aug. 10 interview.
The amount of marketable U.S. government debt outstanding has risen to $9.4 trillion from $4.34 trillion in mid-2007 as the government borrowed to bail out the nation’s banking system and spur the economy out of recession. The U.S. is poised to run a budget deficit of $1.6 trillion this fiscal year.
Treasury yields fell on average to a record 1.27 percent on Aug. 8, the first trading day after S&P downgraded the U.S., according to Bank of America Merrill Lynch index data. Yields on two- and 10-year Treasuries tumbled to all-time lows the next day after the Federal Reserve reduced its growth outlook and pledged to keep its target rate for overnight loans between banks near zero through mid-2013 to help revive growth.
Yields on corporate bonds rated AAA have risen from 58 basis points more than Treasuries in April. The spread averaged about 75 basis points, or 0.75 percentage point, from 1998 through 2001, the last time the U.S. had budget surpluses.
“This is indicative of investors viewing Treasuries as the risk-free benchmark,” said John Milne, who oversees about $1.8 billion as chief executive officer of JKMilne Asset Management in Fort Myers, Florida. “Everything is still trading off of Treasuries.”
Exxon Mobil Corp. (XOM), J&J, Microsoft and Automatic Data Processing Inc. (ADP) are the only U.S. non-financial companies ranked AAA by S&P and Aaa by Moody’s. S&P said Aug. 8 that its downgrade of the U.S. won’t affect companies that carry the top grade.
Exxon, J&J and Microsoft are strong financially and depend less on the U.S. than other companies do because they get much of their income from international markets, the firm said. While ADP earns most of its profits domestically, demand for its products has held up well and it relies little on the public sector and is diversified, according to the statement.
J&J bonds yield 57 basis points on average more than similar-maturity Treasuries, Bank of America Merrill Lynch index data show. Securities issued by Redmond, Washington-based Microsoft, the world’s largest software maker, pay a spread of 55 basis points.
J&J, based in New Brunswick, New Jersey, had $29.7 billion of cash and short-term investments as of July 3, compared with $13.7 billion of long-term debt, according to a regulatory filing. That ratio, combined with the company’s stable and geographically diverse businesses, accounts for its top rating, according to Michael Kaplan, a managing director at S&P.
“They have more cash than debt on their balance sheet,” Kaplan said in a telephone interview Aug. 10. “It’s general knowledge that the U.S. government has a lot more debt relative to those factors that we consider important than J&J does. Based on our criteria, J&J is a stronger credit.”
Ratings should represent the same level of creditworthiness across the spectrum of assets, S&P President Deven Sharma said in a speech on Sept. 21.
“Our goal is to have our AAA ratings, or our A ratings, reflect a comparable view of creditworthiness in one asset class, or one country, as any other, whether it is applied to a Japanese bank or a U.S. municipal,” Sharma said.
It’s not unprecedented for a country to have domestic companies that are rated higher than their government while paying bigger yields on their debt.
Sao Paulo-based Cia. de Bebidas das Americas, or Ambev, is Latin America’s largest brewer and is rated A- by S&P. Its notes due in September 2013 yield 1.64 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Those of BBB- ranked Brazil that mature in June 2013 yield 0.8 percent, Bloomberg data show.
S&P, Moody’s and Fitch drew criticism for ratings of financial products linked to subprime mortgages after losses and write downs by the world’s biggest financial institutions reached $2.1 trillion as measured by Bloomberg data.
The Financial Crisis Inquiry Commission called S&P and Moody’s “key enablers of the financial meltdown” in its January report. In April, a Senate panel said that the rating firms engaged in a “race to the bottom” to assign top grades on mortgage-backed securities in order to win fees from banks.
S&P kept an A- rating on Iceland until October 6, 2008, when the country’s government was forced to guarantee all domestic bank deposits after its currency plunged. It affirmed the AAA grade on Lehman Brothers Holdings Inc.’s financial products unit on Sept. 12, 2008, three days before the bank failed. It cut Bear Stearns Cos. to BBB on March 14, 2008, two days before JPMorgan Chase & Co. agreed to buy the failing securities firm.
S&P gives 18 sovereign borrowers its top AAA ranking, including Australia, Hong Kong, France and the Isle of Man, according to a July report. The U.K., which is estimated to have debt that is 80 percent of its gross domestic product this year, or 6 percentage points higher than the U.S., also has the top credit grade.
U.K. gilts due in 10 years yield 2.48 percent, while French government debt of the same maturity is at 3.06 percent, both higher than the 2.1 percent for Treasuries.
Liquidity, or the ease with which an asset may be converted to cash, is also a reason for Treasuries yielding less than higher-ranked company debt, said John Lonski, chief economist at Moody’s Capital Markets Group in New York. Greater liquidity typically makes it easier for investors to get their money back.
“Liquidity helps explain what’s going on here to a considerable extent,” Lonski, whose division is separate from the ratings group, said Aug. 10 in a telephone interview. “Ultimately the financial markets assign value, not the credit rating.”
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