It is a sign of the times that a blog such as mine, dedicated to micro questions (on corporate finance and valuation), is bogged down on the macro question of sovereign default and its consequences. But there is no getting around the fact that corporations and investors will spend the next week focused on the circus in Washington DC and not on their core businesses. So, let's ask the key questions: What is it that investors fear will happen next week? And what if those fears become reality?
1. Default: Perception versus Reality
The US will not default next week or in the near future, even if there is no debt ceiling legislation passed by August 2. However, the damage has already have been done. The perception that an entity will not default is built not only on the resources controlled by the entity but on the faith that it will always find a way to use these resources to pay its bondholders. Once investors begin debating whether a borrower will default, the faith has been shaken and like Humpty Dumpty, it cannot be put together again.
Bottom line: Investors now perceive the US government as being capable of defaulting on their debt. That will not change, no matter what happens over the next week.
2. Sovereign Ratings and Default
I don't envy the ratings agency that is the first to downgrade the United States, since I am sure that abuse will be heaped on it. But the critics miss a key point. Ratings agencies have more in common with politicians than you may realize: specifically, they are more likely to be followers than leaders. Investors have already starting building in a "default spread" (to cover the likelihood of default) into market prices. While backing this spread out of the treasury bond rate may be difficult to do, it is visible in the Credit Default Swap (CDS) market, where the price for insuring against default on the US treasury has risen over the last few months:
There does seem to be a disconnect between the two markets, with the T.Bond rate decreasing as the default spread in the CDS market rises; you would expect the two to move together. There are a couple of interpretations. The first is that these markets attract different investors, with the nervous nellies (and default risk speculators) going into the CDS market and the oblivious rest holding treasury bonds. The second (and more likely explanation) is that there is information in both markets: the CDS market, for all its faults, is signaling that the default risk in the US Treasury has risen (by about 0.25% over the year) and the the treasury bond market is indicating slower economic growth (and thus lower real interest rates) in the future.
Bottom line: The market has already downgraded the implicit sovereign rating for the United States. An explicit ratings downgrade will still have an effect on bond prices/rates but it will not be a surprise when it does happen.
3. What next?
So, let's assume that the worst comes to pass. Deadlock persists in the DC or is resolved in an unsatisfactory plan. Standard & Poors and/or Moody's downgrades the United States from AAA to AA. Then what?
a. Treasury bond rate: The expectation among many experts is that a downgrade will lead to a surge in treasury bond rates. Given my earlier assertion that a downgrade, if it does occur, will not be a complete surprise to many investors, I don't anticipate a surge in the treasury bond rate, or at least a sustainable one. To make my case, let me break down the treasury bond rate into three components:
T. Bond rate = Expected Inflation + Expected riskfree real interest rate + Expected default spread
If the treasury bond rate already includes a default spread, the day of the downgrade will be ugly for the bond market, with high volatility and big losses for impulsive traders, but I would not be surprised to see treasury bond rates return to pre-downgrade levels within a few weeks. If the ratings change is truly a complete surprise, then the treasury bond market will reflect substantial losses to bondholders on the day of the ratings change.
Bottom line: My expectation is that the treasury bond rate will rise on the downgrade day but not by as much as experts seem to think.
b. Riskfree rate: If the treasury bond rate does have a default spread component, there is a longer term consequence. For decades, when valuing companies in US dollars, we have used the treasury bond rate as the riskfree rate. That practice will no longer hold and the riskfree rate in US dollars will have to be estimated:
Riskfree rate in US dollars = Treasury bond rate - Default spread for the US government
Thus, if the sovereign rating for the US drops to AA+ (with a default spread of 0.25%) and the treasury bond rate is 3.25%, the risk free rate in US dollars will be 3%:
Risk free rate = 3.25% - 0.25% = 3%
A few months ago I posted on a paper that I wrote last year titled "What if nothing is risk free?", a question that no longer sounds hypothetical, but I examine practical ways in which risk free rates can be estimated when sovereign issuers have default risk.
Bottom line: The US treasury bond rate will no longer be the risk free rate in US dollars.
c. Equity Risk Premium: I have always argued that the equity risk premium will increase as country risk increases. Using the US equity risk premium as my base for a mature equity market, I have augmented it by adding a country risk premium, which is a function of the country default spread, obtained from either the rating or the CDS market. A downgrade of the US will cause two changes: a rethinking of what comprises a mature market premium and the adding of a country risk premium for the US. The net effect will be a higher equity risk premium for the US. In fact, using the default spread of 0.25% as the basis, the equity risk premium for the US will rise about 0.38%.
One measure that will capture the effects of increased country risk is the implied equity risk premium that I compute for the S&P 500 at the start of every month. That number has risen over the course of this year from 5.20% at the start of the year to 5.72% at the start of July. I will do my August update in a few days and it will be interesting to see how this number shifts over the rest of the year.
Bottom line: As with the treasury bond rate, if markets have already priced in the higher default risk, the equity risk premium for the US will not jump substantially. If the downgrade is a complete surprise, there will be carnage in equity markets as the equity risk premium will jump,
d. Costs of equity/capital for US firms: Even if risk free rates don't rise significantly, the costs of equity and capital for US firms will increase because of rising equity risk premiums (for cost of equity) and the increase in the cost of debt for all firms (which will now bear some of the burden of sovereign default risk). One simple way to adjust the cost of debt is to add the sovereign default spread to the cost of debt for all firms; thus, with a 0.25% default spread for the US, the pre-tax cost of debt for a US company will rise by 0.25%.
To make this less abstract, let's compare the cost of capital for an average risk firm (Beta =1, Rating = BBB, Debt ratio = 30%) before and after a sovereign downgrade for the US. I have assumed for simplicity that the downgrade is a complete surprise and that the downgrade is to a AA+ and computed the effect on the cost of capital below:
The cost of capital increases by 0.31%, which may not seem like much but will have a substantial effect on value. Given my reasoning earlier, though, I don't think that the increase will be this high, since some or much of the change has already been priced in. You may disagree with the base assumptions and you can change them for yourself in the spreadsheet that I used. Note also that the effect will vary across companies and be much higher for riskier firms, with higher betas and lower bond ratings.
Be prepared for some anomalies. It is possible that a few US corporations may have smaller default spreads than the US government. Let's face it. If you were a bondholder buying bonds, you may feel a lot more secure buying bonds issued by Exxon Mobil than by the US government.
d. Valuation and stock prices: Holding all else constant, higher costs of equity/capital will lower stock prices. An increase of 0.31% in the cost of capital, estimated in the section above, would decrease the value of a mature firm by approximately 5%. (The spreadsheet makes this estimate as well...) What could accelerate this decline, though, is the perception that the sovereign default risk will percolate into fiscal/monetary policy (i.e., the Federal Reserve will become more cautious about pumping in more money into the system and the government has to rein in spending/borrowing) leading to a further slowing down in economic growth and lower earnings. To the extent that the sovereign rating for the US is now in play (and could change), it will add to the volatility in stock prices.
Summing up. To act as if all of this drama will unfold on the date of the downgrade is giving far too much power and weight to the ratings agencies. This process has been going on for months (if not longer) and it is unclear how much the stock and bond markets have already incorporated into prices. A ratings downgrade, if it does occur, will not be a surprise and it is not the cause of economic malaise but a symptom of unresolved economic problems: a government that spends far more than it takes in and has been doing so for a while, households that save too little and borrow too much and a loss of the competitive advantages that the US once enjoyed over the rest of the world. But here is the depressing follow up. Even if there is a debt-ceiling deal by August 2 and the ratings agencies don't downgrade the US, these underlying problems will remain and have to be dealt with, sooner rather than later.
1. Default: Perception versus Reality
The US will not default next week or in the near future, even if there is no debt ceiling legislation passed by August 2. However, the damage has already have been done. The perception that an entity will not default is built not only on the resources controlled by the entity but on the faith that it will always find a way to use these resources to pay its bondholders. Once investors begin debating whether a borrower will default, the faith has been shaken and like Humpty Dumpty, it cannot be put together again.
Bottom line: Investors now perceive the US government as being capable of defaulting on their debt. That will not change, no matter what happens over the next week.
2. Sovereign Ratings and Default
I don't envy the ratings agency that is the first to downgrade the United States, since I am sure that abuse will be heaped on it. But the critics miss a key point. Ratings agencies have more in common with politicians than you may realize: specifically, they are more likely to be followers than leaders. Investors have already starting building in a "default spread" (to cover the likelihood of default) into market prices. While backing this spread out of the treasury bond rate may be difficult to do, it is visible in the Credit Default Swap (CDS) market, where the price for insuring against default on the US treasury has risen over the last few months:
There does seem to be a disconnect between the two markets, with the T.Bond rate decreasing as the default spread in the CDS market rises; you would expect the two to move together. There are a couple of interpretations. The first is that these markets attract different investors, with the nervous nellies (and default risk speculators) going into the CDS market and the oblivious rest holding treasury bonds. The second (and more likely explanation) is that there is information in both markets: the CDS market, for all its faults, is signaling that the default risk in the US Treasury has risen (by about 0.25% over the year) and the the treasury bond market is indicating slower economic growth (and thus lower real interest rates) in the future.
Bottom line: The market has already downgraded the implicit sovereign rating for the United States. An explicit ratings downgrade will still have an effect on bond prices/rates but it will not be a surprise when it does happen.
3. What next?
So, let's assume that the worst comes to pass. Deadlock persists in the DC or is resolved in an unsatisfactory plan. Standard & Poors and/or Moody's downgrades the United States from AAA to AA. Then what?
a. Treasury bond rate: The expectation among many experts is that a downgrade will lead to a surge in treasury bond rates. Given my earlier assertion that a downgrade, if it does occur, will not be a complete surprise to many investors, I don't anticipate a surge in the treasury bond rate, or at least a sustainable one. To make my case, let me break down the treasury bond rate into three components:
T. Bond rate = Expected Inflation + Expected riskfree real interest rate + Expected default spread
If the treasury bond rate already includes a default spread, the day of the downgrade will be ugly for the bond market, with high volatility and big losses for impulsive traders, but I would not be surprised to see treasury bond rates return to pre-downgrade levels within a few weeks. If the ratings change is truly a complete surprise, then the treasury bond market will reflect substantial losses to bondholders on the day of the ratings change.
Bottom line: My expectation is that the treasury bond rate will rise on the downgrade day but not by as much as experts seem to think.
b. Riskfree rate: If the treasury bond rate does have a default spread component, there is a longer term consequence. For decades, when valuing companies in US dollars, we have used the treasury bond rate as the riskfree rate. That practice will no longer hold and the riskfree rate in US dollars will have to be estimated:
Riskfree rate in US dollars = Treasury bond rate - Default spread for the US government
Thus, if the sovereign rating for the US drops to AA+ (with a default spread of 0.25%) and the treasury bond rate is 3.25%, the risk free rate in US dollars will be 3%:
Risk free rate = 3.25% - 0.25% = 3%
A few months ago I posted on a paper that I wrote last year titled "What if nothing is risk free?", a question that no longer sounds hypothetical, but I examine practical ways in which risk free rates can be estimated when sovereign issuers have default risk.
Bottom line: The US treasury bond rate will no longer be the risk free rate in US dollars.
c. Equity Risk Premium: I have always argued that the equity risk premium will increase as country risk increases. Using the US equity risk premium as my base for a mature equity market, I have augmented it by adding a country risk premium, which is a function of the country default spread, obtained from either the rating or the CDS market. A downgrade of the US will cause two changes: a rethinking of what comprises a mature market premium and the adding of a country risk premium for the US. The net effect will be a higher equity risk premium for the US. In fact, using the default spread of 0.25% as the basis, the equity risk premium for the US will rise about 0.38%.
One measure that will capture the effects of increased country risk is the implied equity risk premium that I compute for the S&P 500 at the start of every month. That number has risen over the course of this year from 5.20% at the start of the year to 5.72% at the start of July. I will do my August update in a few days and it will be interesting to see how this number shifts over the rest of the year.
Bottom line: As with the treasury bond rate, if markets have already priced in the higher default risk, the equity risk premium for the US will not jump substantially. If the downgrade is a complete surprise, there will be carnage in equity markets as the equity risk premium will jump,
d. Costs of equity/capital for US firms: Even if risk free rates don't rise significantly, the costs of equity and capital for US firms will increase because of rising equity risk premiums (for cost of equity) and the increase in the cost of debt for all firms (which will now bear some of the burden of sovereign default risk). One simple way to adjust the cost of debt is to add the sovereign default spread to the cost of debt for all firms; thus, with a 0.25% default spread for the US, the pre-tax cost of debt for a US company will rise by 0.25%.
To make this less abstract, let's compare the cost of capital for an average risk firm (Beta =1, Rating = BBB, Debt ratio = 30%) before and after a sovereign downgrade for the US. I have assumed for simplicity that the downgrade is a complete surprise and that the downgrade is to a AA+ and computed the effect on the cost of capital below:
The cost of capital increases by 0.31%, which may not seem like much but will have a substantial effect on value. Given my reasoning earlier, though, I don't think that the increase will be this high, since some or much of the change has already been priced in. You may disagree with the base assumptions and you can change them for yourself in the spreadsheet that I used. Note also that the effect will vary across companies and be much higher for riskier firms, with higher betas and lower bond ratings.
d. Valuation and stock prices: Holding all else constant, higher costs of equity/capital will lower stock prices. An increase of 0.31% in the cost of capital, estimated in the section above, would decrease the value of a mature firm by approximately 5%. (The spreadsheet makes this estimate as well...) What could accelerate this decline, though, is the perception that the sovereign default risk will percolate into fiscal/monetary policy (i.e., the Federal Reserve will become more cautious about pumping in more money into the system and the government has to rein in spending/borrowing) leading to a further slowing down in economic growth and lower earnings. To the extent that the sovereign rating for the US is now in play (and could change), it will add to the volatility in stock prices.
Summing up. To act as if all of this drama will unfold on the date of the downgrade is giving far too much power and weight to the ratings agencies. This process has been going on for months (if not longer) and it is unclear how much the stock and bond markets have already incorporated into prices. A ratings downgrade, if it does occur, will not be a surprise and it is not the cause of economic malaise but a symptom of unresolved economic problems: a government that spends far more than it takes in and has been doing so for a while, households that save too little and borrow too much and a loss of the competitive advantages that the US once enjoyed over the rest of the world. But here is the depressing follow up. Even if there is a debt-ceiling deal by August 2 and the ratings agencies don't downgrade the US, these underlying problems will remain and have to be dealt with, sooner rather than later.
0 comments:
Post a Comment