CREDIT DEFAULT SWAPS ___CDS

[QaB2i]

Sovereign Debt and the Dividend Investor:
What We Know and When We Know It
By Roger S. Conrad1/7/2011Dividend Investing


An unprecedented US government default, spiking interest rates, the loss of “millions” of American jobs, damage to the US dollar and halted payments to millions of Social Security recipients, veterans and active US troops: That’s the dire warning issued by Treasury Secretary Tim Geithner this week, should Congress fail to raise the federal debt ceiling quickly.

Meanwhile, in Europe investors are demanding prices on credit default swaps--which ensure against failure to meet loan obligations--on sovereign debt that suggest at least several countries’ credit ratings should be junk level. That’s no great surprise for the so-called PIG countries: Portugal, Ireland and Greece. Greece, for example, already has a junk rating from both S&P and Moody’s.

What’s considerably more ominous is that credit default swaps for much larger AA rated Spain and A+ rated Italy are priced at levels commensurate with B and BB rated debt, respectively. Even Belgium, which hasn’t been in the news, has credit default swaps in line with a BB rating, rather than its AA+ S&P debt rating.

Moving back to this side of the Atlantic, the US municipal bond market is, more than ever, feeling the strain of busted state and local government budgets. California’s problems are well known. The latest flash point, however, is Illinois, the fifth-largest issuer of municipal bonds and a state plagued with a $13 billion deficit.

Even Canada has its doubters these days. One popular blogger/columnist is making the rounds with the theory that Canada’s banks are only healthy because “the Bank of Canada has assumed nearly all the default risk on Canada’s massive property bubble.” Not everyone agrees, of course, but even Bank of Canada Governor Mark Carney has taken to warning Canadians against debt “complacency,” stating “low rates today do not necessarily mean low rates tomorrow.”

Finally, rumor has it that China is concerned about over-leverage resulting from its loose monetary policy and is looking to tighten again. That’s fueling fears that its double-digit economic growth rate will drop precipitously, with dire economic consequences for countries digging out of recessions by exporting to it.

This last is a major reason the rally in stocks and commodities we saw at the beginning of the week has stalled. And to the extent it becomes reality at least, it will continue to cast a pall over the markets in the coming weeks.

Good News

Now for the good news: If you’re a serious income investor, none of this means beans. In fact, the only significance will be if enough investors get worried and sell, pushing prices of top-quality dividend-paying stocks back into a bargain range.

First off, prognostications of economic doom are increasingly at odds with reality. Even in the long-lagging US unemployment is now dropping, and the Conference Board’s Leading Economic Index is indicating much faster growth in 2011.

We’ve heard warnings of a China slowdown repeatedly over the past couple years. But the fact remains that country can’t afford to tighten much as it accommodates rapid urbanization. And time and again, authorities have shown themselves capable of managing the task of cooling things off just enough to keep them growing. Until they noticeably fail, that’s the bet to make.

The problems of US state and local governments are the result of rising unemployment the past two years, which has depressed tax receipts and increased demand for social services. There are some high-profile situations that could conceivably lead to crises. More likely, however, officials will continue to deal with the shortfalls, which again will disappear as the US economy gains ground.

Europe’s sovereign debt problems are real, as is their challenge to European unity and the euro currency. As we saw clearly during the 2008-09 crisis, however, prices of credit default swaps are a far better gauge of investor sentiment than of real balance sheet strength. And the greater the worry, the more prices will actually over-state the risk of the investment.

That doesn’t mean rising credit default swap prices won’t push up a company’s or government’s borrowing costs. And that in turn will push up interest costs. There is, however, a huge difference between the European debt crisis and the 2008 credit crunch/crash.

Mainly, everyone knows what governments owe now, while no one knew where all the bad mortgage backed securities were back in 2008. The crisis that year got so bad in large part because of the extreme uncertainty that created. No one knew where all the bombs were. That kind of uncertainty just doesn’t exist today.

Finally, Mr. Geithner’s comments notwithstanding, odds of a real US government default from not raising the debt ceiling are slim to none. Rather, what we’re seeing is a direct political challenge from the Obama administration to the incoming Republican leadership in the US House of Representatives. The unmistakable message: Compromise on the budget or risk being blamed for a far worst catastrophe than the 1995 government shutdown/standoff between then-President Bill Clinton and Speaker of the House Newt Gingrich.

Politicians aren’t brain surgeons, or even economists. And it’s very possible for them to do incredibly stupid things, even this far from an election. Much more likely, however, is we’ll see action taken to reduce future US budget deficits and raise the debt ceiling, with minimal disruption to the real economy.

The only important action for investors is always on the company level. Back in 2008, many companies suffered from suddenly restricted credit, as banks pulled in their horns, corporate bond yields soared and plunging stock prices made the cost of issuing equity prohibitively high. The results were falling earnings, dividend cuts and bankruptcies, particularly in leveraged industries like mortgage finance.

The best news in early 2011 is we’re further away from a reprise of that than ever. The biggest contrast is the corporate bond market remains red-hot. Even after a percentage-point back-up in so-called benchmark 10-Year Treasury yield, investment-grade and junk credits alike are still issuing bonds at the lowest interest rates since the 1950s.

After a week of trading in 2011 corporate bond issuances are on the same pace as 2010’s first week. And that year--the most robust for volumes since 1995, according to Dealogic--was pumped up by extremely pent up demand, resulting from the credit crunch of the year before.

Hefty new issue volumes and near record-low borrowing rates present a picture of credit markets 180 degrees distant from the worries swirling around government debt described above. And since we’re buying stocks here, they’re infinitely more relevant as well. Simply, as long as these conditions continue--or anything close to them--there is no credit crunch in corporate America, or debt worries for dividend-paying stocks.

Now for the clincher: Even if credit conditions should tighten sharply in US corporate lending over the next couple months, there would be little if any impact, even if the crunch extended for a year or more.

The reason is companies across the board have taken advantage of extremely favorable borrowing conditions over the past year to dramatically reduce future borrowing needs. Even if rates spiked and demand for debt issues dried up, they can simply pull in their horns and wait for better conditions.

Many of the biggest bond buyers are institutions that are compelled under charter to replenish their portfolios. Sooner or later, they’ll be forced to come back to the market. The result will be another shift in sellers’ favor, and a return of better conditions for new issues, i.e. lower interest rates.

We saw this happen last spring when the first rumblings of Europe’s debt crisis temporarily tightened US credit markets. Now, after another half year of issuing bonds at low rates, companies’ near-term refinancing needs are lower than ever. And because the new debt is far cheaper than what it refinanced, interest costs are lower as well. That means more cash flow, which all else equal means less need to borrow.

Utility companies are one group that’s benefitted immensely. They’ve been able to refinance debt at much lower interest rates and lock in low-cost capital for their ongoing capital spending boom.

Master limited partnerships (MLP) have perhaps been even bigger beneficiaries. Before rates fell, they were forced to rely on lines of credit for their needs. Over the past year, however, they’ve been able to refinance this borrowing with long-dated debt and to lock in low-cost capital to fund further expansion.