Balance sheets matter. As the world is learning, balance sheets of many developed nations are reaching their outer limits. Soaring deficits have pushed debt leverage of many countries to the point where credit markets are questioning their ability to support debt loads.
While many nations, such as Spain and Portugal, have recently announced new austerity programmes, the credit markets are still sceptical that these programmes will be enough. Credit spreads for these nations have tightened since the European bailout package was announced, but they remain as wide as where they were in February, when sovereign credit concerns began to manifest.
The ongoing crisis in sovereign risk has highlighted the differences between investing in corporate and government bonds. For starters, corporate issuers tend to be much more transparent than sovereigns. Every quarter, corporate issuers release financial statements and usually host a conference call for investors to provide greater clarity. Analysts are able to delve into the financial statements to evaluate earnings quality, measure cash flow, and analyse asset quality. In addition, analysts are provided information needed to evaluate off-balance-sheet obligations, such as pension benefits, to estimate how those obligations may affect future cash flows. In contrast, by the time governments release financial statements or economic indicators, the information is often stale. And what do you think the likelihood is of getting Tim Geithner to host an investor conference call?
In addition to analysing macroeconomic trends, sovereign analysis must include other ephemeral issues such as political risks, foreign exchange dynamics, increasing future entitlements, and opaque unfunded mandates that may not be fully disclosed. This crisis has highlighted some of the limitations of the common currency, the euro, and how these limitations hamper the ability of individual nations to manage their finances. Without the ability to print their own currency, these nations lack a monetary means to manage their way out of their predicament. For example, they are unable to devalue their currency to improve the global competitiveness of their goods and services or undertake quantitative easing by repaying maturing debt by printing new currency.
While the credit metrics of many developed nations continue to deteriorate, corporate credit risk generally has improved. Through this recession, corporations have repaid debt, extended maturity profiles, increased cash levels, and improved profitability. The fixed-income markets are recognising these differences in risk and transparency as sovereign risk for many developed nations in Europe are trading at credit spreads wider than similarly rated corporates.
While not an immediate concern, it's a bit worrisome that the short-term funding market has not improved. The TED spread (difference between LIBOR and short-term government bills), which is an indicator of credit counterparty risk, continues to widen. Despite the significant efforts of central banks to easy liquidity concerns, counterparties are increasingly apprehensive about lending excess capital. Three-month LIBOR increased slightly to 0.45% and the TED spread widened to 0.22% from 0.17%.
Short-term funding rates should have tightened or at least held steady after the announcement of the EU bailout package, which was meant to alleviate the risk of short-term lending to European banks. This represents the first notable widening seen in the short-term funding markets since the March 2009 equity market bottom and is indicative of increasing risk aversion.
