Credit vs sovereign debt

France has become a poster child for what happens when bond investors lose faith in something that hitherto has been a safe haven. Their pronouncement has been withering: a substantial proportion of the country’s corporate sector can now borrow more cheaply than the French government.

France might be an extreme case, but it’s not unique: this is already a common phenomenon in emerging markets. And the investor revolt could well infect other big economies. In the UK demand for the latest auction of 5- and 30-year gilts was the lowest in at least two years, while Japan’s recent auction of two-year government bonds saw the lowest demand since 2009.

The nervousness about sovereign safe havens boils down to politics. For instance, in France’s case, a rolling political crisis has made it impossible to form a government that is able to take control of state finances. Voters revolt at the smallest sign that any of their benefits are being taken away – be it lengthening the work week, or extending the retirement age. Even though pension incomes for French retirees are, on average, higher than incomes for working-age people. It’s an unsustainable state of affairs.

Other developed countries aren’t quite at the same point as France, but they’re heading in the same direction, not least because of demographics. People are having fewer children while also living longer. And governments are beholden to this big cohort of retired voters. So, for instance, the US has been running a chronic deficit of 6% of GDP or more – the lion’s share ear-marked for social spending – with little sign of it being cut. When the economy is only growing at between 2% and 3%, that leads to a rapidly expanding debt load. Indeed, advanced economies overall saw their public debt burdens rise by 10 percentage points to 117% of GDP between the fourth quarter of 2017 and the third quarter of 2025. Eventually, investors baulk at buying more debt.

By contrast, many of the biggest multi-nationals have seen their creditworthiness improve. In most cases, investment grade companies boast solid balance sheets, good earnings prospects and healthy and sustainable margins. Loans to investment grade borrowers have in any case always been highly secure – historic default rates in Europe hover around 0.5% – but for the very best of these borrowers, default is vanishingly improbable. Governments who operate their own currency can avoid actual default by printing money – though investors demand a premium for inflation risk. But France, as a member of the euro zone, doesn’t have this option – which is, in part, why a growing proportion of French corporate debt trades at lower yields than French sovereign debt at equivalent maturities (see chart).

This set of circumstances isn’t unusual in less developed countries. There, debt issued by the best corporations, with global operations and reliable access to foreign currency, often trades at yields below that of their home governments, which sometimes struggle to maintain foreign currency reserves to pay off their often dollar-denominated debt. For example, more than 30% of Brazilian and some 10% of Mexican and Colombian corporate credit trade below their respective government bonds on a duration-matched basis, according to BofA research.

But that doesn’t mean corporate debt is taking over as a safe haven of choice.

For one thing, governments can tax companies. Both the UK and Poland have threatened to tax their banking systems to fund their fiscal expansion. Poland, for instance, wants to increase taxes on their banks’ profits specifically to fund the country’s defence spending. There is, however, a balance to be struck. Companies can change domicile to more favourable regimes. The Netherlands and Ireland have both benefited from an influx of firms that otherwise have little connection to the countries.

Governments are likely to aim at easy targets – like banks. Public perception is that banks have generated excess profits in recent years, while the banks themselves are tied to local markets both by regulation and the sources of their business, making it hard for them to shift domicile. By contrast, heavy industry and manufacturing companies tend to be big local employers with relatively tight margins, while service companies can often move overnight.

The trick for governments will be to figure out how much they can squeeze companies without causing significant damage to their own economies. At some point, companies will take their business elsewhere or their earnings will start to suffer, causing them to retrench. For now, though, high quality corporate credit looks healthier than the sovereign alternative across a growing number of developed countries – which means it makes sense to have a bigger allocation to credit at the expense of government debt.