Spectrum of Risk from Guaranteed Financial Instruments

In one of the best scenes in the classic 90’s movie Tommy Boy, Tommy, played by Chris Farley, discusses the nature of guarantees.

 In the scene, a buyer tells Tommy that he will only be interested in buying brake pads if there is “a guarantee on the box.”   Tommy then dispels that notion (in crude but hilarious terms) and asserts that the guarantee on the brake pad box is only as good as the company guaranteeing it.

This assertion – that a guarantee is only as good as the guarantor – is just as true in the world of finance as it is the world of Tommy Boy’s brake pads.

Guarantees in Finance

In finance, a guarantee is successful if you are delivered what you are promised.  In the most common case, the bond you bought pays your scheduled interest payments on time and you receive your original investment (i.e., principal) back at maturity.   If there is some deviation from the interest or principal guarantee, then the guarantee is bad and your bond is in default.

As you would imagine, there are multiple categories (and sub-categories) of guarantees in finance – ranging from Treasuries guaranteed by the US Government to Bonds guaranteed by private Corporations.  The primary rating agencies – S&P and Moody’s – typically cover all bond categories, and can provide a basis for apples-to-apples comparison of quality – or likelihood of default – of various financial guarantees.     In ranking the relative value of each guarantee, we’re considering what Moody’s considers to be the highest quality subset in each category (A and higher).    

This post only considered the relative value of the guarantees of highest quality in each of the fixed income categories (Moody’s A and higher).  In a later piece, we’ll explore the relative value of the guarantees of the lower quality tiers of each category (BBB and below).

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Guarantee (ranked by historical 10 Year cumulative likelihood of default)

1.United States Treasuries/ Certificates of Deposit

Debt issued by the United States government is both very liquid and high quality (Moody’s AAA).  The US government has never defaulted on its debt.   Interest from Treasuries is subject to Federal tax but exempt from State income tax.

FDIC insured Certificates of Deposit, up to the FDIC-limit ($250,000 for individuals) have likewise never broken a promise to return the FDIC-insured amount.

2. Municipal Bonds

Municipal bonds are those issued by state, city and local governments to finance projects that benefit the public (e.g., schools, roads, sewers, etc.).  Interest from muni bonds is generally tax-free at the Federal level.   From 1970 to 2016, less than 0.10% of muni bonds rated A and higher experienced a default over any given 10-year period in that timeframe.

3. Corporate Bonds

Guarantees from corporate entities are the next rung on the ladder. Over this same time period (1970-2016), even the highest quality global corporate bonds experienced significant defaults — 3.38% of A and higher rated corporate bonds experienced a default over any given 10-year period.

4. Sovereign Debt

Guarantees from countries outside the US haven’t fared as well.  According to Moody’s, between 1983-2016, close to 6% (issuer weighted) of A and higher rated sovereign bonds experienced a default over any 10-year period.  Of course, it only takes one apple to spoil the bunch, and Greece, which has been in default for 50% of its time as an independent country (including most recently in 2012), was considered A rated by Moody’s until recently.

While no one knows what’s going to happen in the future, the lessons of the past should at least provide some basis for judging the relative value of each guarantee.

Sources

https://www.researchpool.com/download/?report_id=1412208&show_pdf_data=true

https://www.researchpool.com/download/?report_id=1416505&show_pdf_data=true