If you read an intermediate level finance textbook, you will encounter advice that discusses the relative safety of bonds. Usually, you will encounter information that says something to the effect of—national governments have the safest debt obligations, then state and/or local governments, then large businesses, and then small businesses. Those notions may be useful as vague generalities, but provide little insight when you are actually trying to determine how to invest your money: What are the exceptions? How can you tell when, say, a high-quality large business is giving you a “safer” bond offering than a government entity?
No matter what type of bond investment you are contemplating, the analysis of bond safety will always require two steps.
First, you determine the quality and scope of the cash flows that are the source of underlying support for the bond payments. In the case of governments, you examine the revenue-generating capacity over all the business activity in their jurisdiction. With businesses, you should focus the most on cash flows, both free and restricted.
Secondly, you examine the interests that rank head of you in making a claim on those cash flows. If it is a government, you examine whether there is a backlog of bills, pension obligations, payroll, etc. that may get paid ahead of general bondholders. The ranking priority order is a little bit different depending on your country or state of jurisdiction. In the United States, it is a general rule that payroll must get paid before unsecured bondholders of a business or a bankruptcy trustee has the power to “avoid” those payments and is entitled to receive a judgment on behalf of the bankruptcy estate from the unsecured creditor that got paid before the payroll obligations.
This means that there are times when the unsecured debt of a multi-national business is better than that of a state government.
I’ll give an example. In 2015, Nestle offered bonds that yielded 3.8%. At the time, the business earned a net profit of $9.4 billion selling cookies, milk, and an enormous array of 15,800 food items in 186 different countries. The balance sheet had $18 billion in debt, with $12 billion of it going to secured creditors.
It is not uncommon to find instances when blue-chip businesses issue bonds that have a better risk profile than government entities. I would rather have a relatively unencumbered claim on a fraction of the cash flows from a centuries-old chocolate empire than a claim backed by the taxing power of a statist regime in turmoil.
Cumulatively, this meant that $12 billion in claims against Nestle would get paid out before you, and then you belonged to a category of other investors that were tied for a claim on the next $6 billion.
If you put it in monthly terms, your analysis of 2015 payment rights could best be explained like this: Nestle generates $830 million in cash flows per month. Of that, about $20 million goes towards secured creditors each month. The next $30 million goes toward the class of people collecting that 3.8% from the bond offering. And after that, the remaining $780 million or so is the net profit that is attributable to shareholders.
That is a pretty safe place to be. You have a claim on the $20,000,001 through $50,000,000 range on the monthly balance sheet of an entity that has been selling the same products for almost 130 years and has generates over $800 million in cash flows each month. Putting aside the usual caveat that there are no guaranties in life, this situation is on the short list of the greatest assurances you can find that you will get paid.
Also in 2015, you had the opportunity to purchase an Illinois bond that yielded 3.5%. At the time, Illinois was nearing a $10 billion backlog of unpaid pills, and was spending $250 out of every $1,000 in tax dollars on pension obligations and health benefits. Approximately $30 out of every $1,000 raised was going towards interest on the debt obligations, which doesn’t sound so bad at first, but slides a bit more on the terrifying spectrum when you consider that the money was issued in an unusually low-interest rate environment.
Meanwhile, Illinois hasn’t had a balanced budget since 2001. The average annual budget deficit, again from a 2015 perspective, was in the $3-$4 billion range. This means that if you buy Illinois bonds, you will know that each year someone is either joining your class of claimants or buying debt that ranks ahead of you (Illinois has imposed many restrictions against taking out secured interests against government-owned buildings, so what usually happens is that, say, a small courthouse will be sold to a private investor and then the state of Illinois would become a tenant in a transaction called a sale-leaseback.)
Because of backlogs, payroll, pensions, health-care for government workers and other matters that Illinois has chosen to enshrine in its Constitution rather than statute, a purchaser of an Illinois bond has a claim on dollars 33 through 67 out of 100 in revenue raised and that class of creditors expands every year due to budget deficits. And given that Illinois ranks 46 out of 50 in the United States in terms of tax friendliness, you cannot presume much room for additional revenue to be raised by tax increases.
How does this framework of analysis benefit you? Well, it leads me to the conclusion that you are being paid more for taking on less risk if you chose to collect a 3.8% Nestle bond in 2015 over a 3.5% Illinois bond. How did this inefficiency exist? Because most people are taught to assume that taxing power is superior to earnings power, and priority status is nearly irrelevant in state finances because everyone historically seems to get paid eventually.
But I argue that the foundation for making payments is superior for Nestle than Illinois because its product line is so vast, its earnings power so deep, and its range of priority creditors generally insignificant compared to the earnings power because the Swiss seem to have financial conservatism embedded in their DNA. That financial prudence has not gotten into the Springfield water in the Land of Lincoln. If you compare the reliability of the cash flows to the people that will get paid ahead of you, and use that as your framework of analysis rather than generic rules of thumb, you can pick up a bit more income for a bit less risk in the bond market.
Originally posted 2017-06-03 17:44:58.
