Wednesday, October 16, 2013

Chill, dude (Part II): Debt Default Drama Queens

When I took my first finance class, I was taught that the government bond rate in the currency in question is the risk free rate. Implicit in that teaching was the assumption, misplaced even then, that governments do not default on their local currency borrowings, since they control the printing presses. When confronted with evidence of government defaults in the local currency in prior decades, the defense offered was that these defaults occurred in tumultuous emerging markets but would never happen in developed markets. I took that teaching to heart and for almost three decades used the US Treasury bond unquestioningly as the risk free rate in US dollars. With the government default looming tomorrow, you would think that this would be a moment of reckoning for me, but my faith in governments being default free was lost a while back, in September 2008. For those who do remember that crisis (and it is amazing how quickly we forget), there were two events that month that changed my perceptions of government default. The first occurred on September 17, 2008, where money market funds (supposedly the last haven for truly risk averse investors) broke the buck, essentially reporting that they had lost principal even though they had invested in supposedly risk free, liquid securities. The second happened a week later, when the nominal interest rate on a US treasury bill dropped below zero, an almost unexplainable phenomenon, if you believe that the US government has no default risk. After all, why would investors pay more than a thousand dollars today for a T.Bill for the right to receive a thousand dollars in the future, unless they perceive a chance that they will not be paid?

That last question is the key to understanding default risk. It is not a zero-one proposition, where it shows up only after you have defaulted. If an entity is truly default free, the question of whether there is default risk will never come up, and if it does come up, that entity is not default free. Put in specific terms, I believe that markets have perceived and built in some default risk in the US Treasury since 2008, though it is perhaps small enough to ignore. The issue was crystallized two summers ago, when S&P announced its ratings downgrade for the US, to screams of protest from politicians in DC. At the time, I posted my reaction to the downgrade and advised investors to take it down a notch and that while the downgrade was definitely not good news for any one, it was not the end of the world that it was made out to be. 

Market Assessments of US default risk
To back up my point about how default risk is not a zero one proposition to markets and investors, I will start with a graph of credit default swap spreads for the US on a monthly basis from January 2008 through today. While I have posted about the limitations of the CDS market, it provides a barometer of market views on sovereign default risk that are much more timely than sovereign ratings.

Looking at the chart, it is clear that the crisis is 2008 changed market perceptions of default risk in the United States. The US CDS spread increased from 0.105% in January 2008 to 0.73% in January 2009. While that number dropped back for a while, it started climbing again in late 2010 and the S&P downgrade in August 2011 had little impact on the spread, suggesting that as always, ratings agencies follow markets, rather than lead them. Updating the numbers through this year, the US CDS spread has dropped over the course of the year and the debt default drama has had little impact on that number, suggesting again that while the recent events in Washington may have increased investor concern about default risk, the effect is not as large or as dramatic as it has been made out to be.

If you are concerned that the month to month graph might not be indicating day to day volatility in the market, this graph should set that fear to rest:

Some analysts have pointed at the increase in the T.Bill rate as evidence of market concern about default and there is some basis for that.

The one-month T. Bill rate has climbed from zero in mid-September to 0.35% yesterday. However, note that the US T.Bond rate actually declined over the same period, again indicative that if there is a heightened sense of worry about default with the US Treasury, it is accompanied by a sense that the default will not last for long and will affect short term obligations by more.

Valuation Implications
What are the implications of heightened default risk in government bonds for risky assets? In the immediate aftermath of the 2008 crisis, I worked on a series of what I call my "nightmare" papers, where I took fundamental assumptions we make about markets and examined how corporate finance and valuation practice would have to change, if those assumptions were not true. The very first of those articles was titled, "Into the Abyss: What if nothing is risk free?" and it looked at the feedback effects of  government default into valuation inputs. You can download the paper by clicking here, but I can summarize the effects on equity value into key macro inputs that affect the value of every company:

1. Risk free rate: How will a default or a heightened expectation of default by the US government affect the risk free rate in US dollars? It is tough to tell, but my guess is that the risk free rate in US dollars will decline. That may surprise you, but that may be because you are still equating the US treasury bond rate with the risk free rate in US dollars. Once government default become a clear and present danger, that equivalence no longer holds and the risk free rate in US dollars will have to be computed by subtracting out the default spread for the US from the US treasury bond rate. Thus, just as a what if, assume that there is default and the US T.Bond rate jumps from 2.60% today to 2.75% tomorrow and that your assessment of the default spread for the US (either from a newly assigned lower sovereign rating or the CDS market tomorrow) is 0.25%.
Risk free rate in US dollars = 2.75% - 0.25% = 2.50%
Why do I expect the risk free rate in US dollars to drop? A pure risk free rate is a composite of expected inflation and expected real interest rate, and as I have argued before, reflects expectations of nominal growth in the economy. A default by the US treasury will affect both numbers negatively, since it may tip the economy back into a recession and bring lower inflation with it. In fact, looking back at the daily T.Bond rates and CDS rates over the last month, I tried to break down the T.Bond rate each day into a risk free US $ rate and an estimated default spread. To estimate the latter, I compared the CDS spread each day to the CDS spread of 0.20% on August 31, 2008.
If you go along with my estimates, the US $ risk free rate has dropped from 2.67% to 2.42% over the last 30 days, while the default spread has widened from 0.19% to 0.28%.

2. Equity Risk Premiums and Corporate Default Spreads: Lest you start celebrating the lower risk free rate as good for value, let me bring the other piece of the required return into play. If the default risk in the US is reevaluated upwards, it is also very likely that investors will start demanding higher risk premiums for investing in risky assets (stocks, corporate bonds, real estate). In fact, I think that the absence of a truly risk free alternative makes all risky investments even riskier to investors and that will show up as higher equity risk premiums. The same argument can be applied to the corporate bond market, where default spreads will increase for corporate bonds in every ratings class, as sovereign default risk climbs. To get a measure of how equity risk premiums have behaved over the last month, I can provide my daily estimates of the implied ERP from September 16 to October 16 for the S&P 500.

Note that I have computed the implied ERP over my estimated US$ risk free rate (and not over the US T. Bond rate). You can download the spreadsheet and make the estimates yourself. The net effect on equity will therefore depend upon whether equity risk premiums (ERP will increase by more or less than the risk free rate decreases. If default occurs, the ERP will increase by more than the risk free rate drops, which will have a negative effect on the value of equity. However, that effect will not be uniform, with the negative impact being greater for riskier companies than for safer ones.

The End Game
By the time you read this post, I would not be surprised if Congress has stitched together a last minute compromise to postpone technical default to another day. In a sense, though, it is too late to put the genie back in the bottle and while it is easy to blame political dysfunction for this debt default drama, I think that it is reflective of a much larger macro economic shift. With globalization of both companies and markets, even the largest economies are no longer insulated from big crises and in conjunction with the loss of trust in institutions (governments, central banks) over the last few years, I think we have to face up to the reality that nothing is truly risk free any more. That is the bad news. The good news is that the mechanism for incorporating that shift into valuation and corporate finance exists, is already in use in many emerging market currencies and just has to be extended to developed markets.


Stock Market Beat said...

"After all, why would investors pay more than a thousand dollars today for a T.Bill for the right to receive a thousand dollars in the future, unless they perceive a chance that they will not be paid?"

You lost me on that one...

shartig said...

I'm assuming the US CDS rates you posted looked at 5 year spreads? They seemed to be roughly unchanged.

However, the US CDS yield curve inverted on October 3rd (with 1 year CDS increasing from .38 to .64). At the time I considered this evidence that the market did price in some risk of default? At the very least I found it interesting. I don't get real time data through Capital IQ but I'm interested to see what it looks like tomorrow.

Thanks for post, as usual a great read.

Rishu Ranjan said...

I think investors were paying more than thousand dollars to receive thousand dollars in future not because of US default probability but because nobody trusted banks for the short term deposits and hence the Tbill market was flooded. If you price US default in deposits then you would rather pay a fraction to recive a thousand dollar in future. said... offers personal loans services in singapore.if you want to any type of personal loan in singapore then plz contact us.

Anonymous said...

"After all, why would investors pay more than a thousand dollars today for a T.Bill for the right to receive a thousand dollars in the future, unless they perceive a chance that they will not be paid?"

I am sorry, but you are plain wrong on this one. They (market participants) were paying more than a thousand Dollars (negative nominal interest rates), because they perceived the default risk of any other short term (liquid) investment (CD, Commercial Paper, etc.) has gone up. The other alternative would have been cash, i.e. dollar bills, but you cannot store a trillion dollars in cash without incurring transportation costs or costs for storage. That is the only reason why the nominal rate on t-bills turned negative. The market did not price in any default risk in short term treasury securities.

That is basic arbitrage theory.

Aswath Damodaran said...

So, why not just hold on to the cash? Keep it under your mattress? Is it the risk of being robbed that high in the neighborhoods that these portfolio managers live in?

Stock Market Beat said...

If a portfolio manager takes my cash home and puts it under the mattress I am calling the cops. Plus, if it's a portfolio manager of any decent size he'd need a helluva large mattress.

Aditya said...

I guess what the professor meant to say is that money market funds and other institutions are willing to receive 97 cents on a dollar in a very short term maturities like a week or two rather than wait for 2 months or more and live in uncertainty about whether they will receive atleast those 97 cents on a dollar or in extreme cases loose their principal completely... if you read the second article in that paragraph the interest rates on 2 years notes have ballooned as investors want to be in a very short term treasuries and sold there holdings in anything that they perceive as risky and take even a negative yield on ultra short dated treasuries

Aswath Damodaran said...

Stock market beats,
If a portfolio manager invested my cash at a -3% nominal return, I would fire him as well. Why not return the cash to me? I think I could have found a mattress big enough for just my portion of the cash.

Rishu Ranjan said...

Sir, I think we are talking about money market instruments which run in billions of dollar. Imagine the cost of keeping billion dollars secure in some vault or something, I think it will be much more than the "negative premium" they would pay.

Anonymous said...

Most of Wall Street calculated cost of equity using CAPM, using Treasuries as the risk free rate.
The Ibbotson SBBI Valuation Yearbook is widely used and publishes the equity risk premium which is either a historical or supply side.

Is that market risk premium no longer sufficient to capture the risk? How should this methodology be adjusted?

Aswath Damodaran said...

I don't think it makes much of a difference in your overall cost of equity. Your risk free rate will be a little lower (below the US T Bond rate) and your risk premiums are much higher. If Wall Street is screwing up valuations, this is the least of your worries.

CH said...

Hmm Perhaps, the money market fund manager has an investment mandate that requires him to stay "invested" and are allowed to hold cash up to a certain percentage?

Or it is suggesting that the fund managers doesn't even trust their counterparts(banks/FIs) that hold their cash or the custodians of their money market investments, that they rather lose some money to roll it with short T-bills from the government.

Then again, if I turn it around and I take a $100 from you and give you back $97 tomorrow because you have no place else to keep it for the night. I am really being an asshole! Imagine your bank deposit literally decreases every day! Inflation made tangible immediately.

Just thinking aloud..

baz brant said...

Aswath ,
As usual a pretty concise summary of events .
Of interest , has the bond rates for others (ie, not US ) . Reacted inversely in equal proportion ?
Keep up the good work .

Avid reader ,

Nicolas said...

With respect to the increase in CDS, I understand that the volumes remain very low compared to the size of a US default. Hence the market is not looking for protection. I think the US CDS market is more about technical default. In this case you would buy a protection for cheap and if default there is you can bring to the counter party some bonds and get 100 for them. The trick would then be to buy some bills trading at a low price (some trade below 90)and pocket the difference. Simple technical arbitrage.

Davi Genaro said...

Interesting discussion as always - computing the "risk free" rate by subtracting the CDS spread from the bonds yields. Now a few questions come to mind, which are:

(1) market definitely does not seem efficient in that sense, since the CDS has its flaws and is not liquid, but more than that, just too much regulation and market practice pointing today to the US Treasury as risk free (and therefore distorting the markets supply and demand of those bonds)?
(2) shouldn't we use a CDS spread in USD (the US one is in EUR so there is a conversion there to be made)
(3) What really are the odds that the US government will default in its own currency? Yes, there are limits to printing currency, but also there is a constitutional obligation to not default on the debt. Throughout history, which countries have defaulted in local currency? Because then the effect of higher expected default will not necessarily be reflected in the CDS, but rather in treasury yields and the dollar value?

Kylie said...

Another great post Professor, thanks for sharing!

Beat said...

"After all, why would investors pay more than a thousand dollars today for a T.Bill for the right to receive a thousand dollars in the future, unless they perceive a chance that they will not be paid?"

I also think this thinking is not correct. If T-Bills were perceived as risky as you described, then nobody would pay more than thousand dollars today to receive thousand of unsecure dollars in future. In this case we would expect the opposite (ivestors would pay far less then thouasand dollars today for this promise), i.e. higher positive interest rates.

Negative rates are therefore a sign for safe havens in very unsecure times (for example Switzerland had negative rates as well for a certain time).

Rahul Maniar said...

I am sure it is still being taught in business school that corporate should pay more than government because governments have unlimited taxing power. Hence if yields on government bonds go up so do yields on corporate bonds. Interestingly the debate which took place in Washington was due to differences in opinion regarding how to reduce deficits and republicans were willing to default in order to restrain spending. The current set up in US politics appear make it very difficult to raise taxes on corporates though that is what democrats would like and US public opinion also appear to be against tax increases. If this is indeed the case then corporates like Apple, Exxon, Microsoft, Google should be able to borrow at rates lower than equivalent treasuries. Question to the professor is: shouldn't risk premium associated with such companies with net cash on balance sheet be negative?