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.
How helpful/hurtful do you think ron paul's views would be to the underlying issue. He has been bringing a lot of attention to the Fed. Is this undue?
ReplyDeleteU summed up really well...I totally agree with U...Well written!!
ReplyDeleteAmar
Prof.
ReplyDeleteThe bond markets have already priced in an implicit default; I suppose going forward foreign investors may perhaps have more reason to be concerned on the fact if the US may in fact inflate away its debt, through a gradual decline in the value of the greenback. This will harm countries like China, Japan the most (holders of US Treasuries), however on the contrary help US in reducing its deficit.
May sound a bit wicked, however do you think this is what the chaps are up to?
Kindest,
Krishnan
This comment has been removed by the author.
ReplyDeleteVery well framed!!
ReplyDeleteHow does the model change to admit the Japanese scenario, where rates continue a long decline even after a downgrade?
ReplyDeleteI am a bit confused. Why is the country risk premium (0.38) different from the default risk premium (0.25)? Thanks.
ReplyDeleteTO DV: The reason why the country risk premium is .38 is because the original .25 premium is computed for the T-bond market. The spreadsheet scales this number up by 1.5 in order to assume an equity market default premium (stocks are more risky, volatile, than T-Bonds).
ReplyDeleteAlas,finally US got senate approval for an extension of its borrowing limit and comments have been spread accross the community that this ( printing/borrwoing of more money ) will lead to furhter inflation in commodity prices. Will it hurt the middle ( working ) class community of developing world in terms of money to be spent on food and other lively hood ?
ReplyDeleteRegarding DV's question, I definitely agree with the answer served by Wonderlight. I would just like to add that a way to capture the scaling up factor is to compute the ratio between the average standard deviation of US equity market and the average SD of US bond market.
ReplyDelete@DV
ReplyDeleteBecause the broad equity market in the US don't have the same risk as the us treasuries, but a higher one.
The country risk premium applies only for the state's titles themselves, and for the companies to be perceived to have the same risk as the government, or even a lower risk. For the rest of the companies, the risk premium is higher.
Very interesting article, thanks Professor.
ReplyDeleteHowever, I wonder why exactly the US sovereign credit spread impacts the cost of debt for an individual firm. I would assume that the country risk component is already priced into the corporate's credit spread (as expressed by its CDS rate). Likewise, I assume that a corporate's rating as determined by agencies already reflects circumstances such as the firm's geographic location and the corresponding political, financial, monetary and further environmental risks.
In this context, can anyone please explain why a firm's cost of debt is not merely comprised of the (US CDS adjusted) riskfree rate and its corporate credit spread?
Very smart question, indeed! Professor Damodaran, would be great if you could elaborate on that...
ReplyDeleteGreat post professor! However, don't you think the default-spread of 25-bp would already be modeled in an implied ERP model (we subtract the market premium from risk-free rate)? And it's just the excess 13-bp that needs to go into the ERP as a country risk premium and not the entire 38-bp?
ReplyDeleteGood question on the cost of debt. It is true that a company does not have to be saddled with the default risk of the country in which it is incorporated. In fact, some companies (like Petrobras in Brazil) have been able to borrow money at rates lower than the sovereign. Here is the catch, though. Even those companies face some of the burden of sovereign risk and most small companies really have no escape. If you think it is unfair, talk to any Venezuelan company...
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