Monday, March 22, 2010

Government Default and Riskfree Rates

I have several posts on potential government default and riskfree rates. I noticed this story in Business Week.

I know that this is only one observation but it is a troubling one. In emerging markets, it is not uncommon for companies to borrow money at rates lower than the government, but the saving grace is that the borrowings are in a foreign currency. I can see why bond holders saw less default risk in dollar bonds issued by Petrobras in 2004 than in dollar bonds issued by the Brazilian government.

In this case, lenders are actually perceiving less default risk to Berkshire Hathaway than to the US Government, for a US dollar bond. I know that Berkshire Hathaway has a much healthier balance sheet than the US government, but the US government has the power to print currency. Thus, I would not read too much analytical significance into the 3.5 basis point different. However, I think the market is sending a message to the US government which might or might not be getting through: You have to get your financial house in order soon or you will pay a price. Let's hope that someone is listening.


Dean said...

The linked Bloomberg article also forgets to mention the fact that U.S. treasuries are far more liquid than Berkshire bonds. Just look at the bid ask spreads for both bonds and you will quickly understand that 3.5 basis points isn't much indeed.

Aswath Damodaran said...

Liquidity, though, should help the US treasury bond and raise its price (and lower the yield). But I agree with you. The spread is too small to be significant and may in fact be due to subtle differences in the ways the bonds are structured and traded.

Rahul Hari said...

I have been following the blog quite religiously, however I'm curious about the comment "US govt. having the power to print currency". Since printing currency could increase the inflation rates further, shouldn't the probability of govt. printing the currency to pay debt be quite low ?

Fabian said...

We should not forget that the us government has intervened in the bond market with its quantitative easing strategy. Therefore, the interest rats are manipulated and definitely lower than without such ordinary measures. In my opinion the spread should be even higher.
Furthermore, the us government finances 1/3 of the $ 12 trillion debt trough intragovernmental holdings (pension systems) - it all looks like a huge ponzi (madoff) schema.

Aswath Damodaran said...

When it is a choice between inflation and default, I think the former wins out.

Dean said...

I agree. Liquidity does in fact help US Treasuries (that's why there is a difference between on-the-run and off-the run bills.) However, my suspicion is that idiosyncratic risk is reflected better in US Treasury prices than in Berkshire prices. It would be interesting to compare the yields of the two bonds if, like the US Treasury, Berkshire would also issue new 10Yr debt every month.

ayazmo said...


how would the roce dimension work across different countries primarily based on different levels of inflation and thus bonds rates which form the basis of your return expectation



Unknown said...

The fear of the US Govt losing its AAA rating is in itself a myth.

If Moody's belief in Supremacy of Sovereignty is the reason for the "coveted" rating, how does it really matter if Berkshire is borrowing for less.

If, on the other hand, ratings need to reflect inherent efficiency of market players in a dynamic scenario, Moody's rating is not merely questionable but outrightly absurd.

James said...

Hi Aswath,

In your 2010 ERP paper, you mention that you "used analyst estimates of growth in earnings for the 5-year growth rate after 1980" (footnote 77). Where did you find these historical analyst estimates? I'm interested in looking at mean reversion in the implied equity risk premium over a shorter time period (e.g. 1990 - 2010) and would like to calculate monthly implied ERPs.

Do you think this is a feasible task (even if I was to use actual dividend growth rates), or are historical monthly implied ERPs beyond our reach?