Is McDonald’s now a safer bet than HMG?

‘What do you say to a former Treasury economist? Big Mac and fries, please!’ This updated version of the old 1980s joke (the original butts were sociology graduates, and any scouser in uniform) has yet to make it into wider circulation, but it can only be a matter of time. If faced with such a career opportunity, though, a civil servant would arguably be well advised to take it, for the sake of financial security. Because, if global bond markets are to be believed, McDonald’s is now a more reliable institution than Her Majesty’s Government — a fact that has implications for anyone with less appetite for risk than for cholesterol.

This unlikely conclusion emerges from the current pricing of corporate and government debt. At present, UK government stock, known as gilts, still nominally receive the highest ‘AAA’ rating from all the credit reference agencies — an accolade shared only by corporate bonds issued by multinational leviathans such as General Electric, Exxon Mobil and Microsoft, and the now-nationalised US Federal Home Loan Mortgage Corporation, known as Freddie Mac.

By contrast, McDonald’s latest bond issuance was only rated single ‘A’ by Fitch. However, the credit default swap (CDS) market tells a different story. CDSs are contracts that pay out if a bond issuer defaults — so their price, like any insurance premium, reflects the perceived risk of that eventuality. Right now, to insure £1 million worth of McDonald’s bonds against default in the CDS market costs £6,240 per year. But to insure £1 million worth of UK government bonds costs £15,710.

According to Lincoln Financial’s senior investment analyst, Stuart Tyler, ‘This difference is based on the perception of overseas investors that, given the amount of bank bail-outs and the cost for the UK government, then there is a risk that this could break the government’s finances.’ Or, in other words, Ronald McDonald now looks a better bet than Alistair Darling.

Before gilt investors choke on their McNuggets, it should be said that there is a certain absurdity in this pricing. As the hamburger chain cannot (yet) print its own money or raise its own taxes, HM Government should have a lot more scope to underwrite its own bonds. ‘McDonald’s, by contrast, can only increase the price of a Big Mac so far,’ concedes Tyler. Also, the prices and yields of the bonds themselves give a more accurate reflection of the relative risk: McDonald’s ten-year bonds currently have to offer about 1.7 per cent more yield than gilts to persuade uncertain investors to bite. Nevertheless, government bonds are clearly no longer so gilt-edged that they can’t be outshone, in the eyes of some, by the Golden Arches. CDS traders have even demonstrated more stomach for Kellogg’s and Coca-Cola bonds than gilts in recent months. Evidently, concerns about default risk in government bonds are beginning to be raised by investors — a previously unheard-of situation.

‘Over the past few months, the trend of rising “sovereign default” risk has accelerated — particularly in Europe where we’ve seen downgrades to the sovereign debt of Greece, Portugal and Spain,’ explains Stefan Isaacs, one of M&G’s fixed-interest fund managers and author of its Bond Vigilantes blog. ‘It’s probably only a matter of time until the UK follows. According to the credit derivative market, there is a slightly higher risk of the UK government defaulting than for Belgium (rated AA+), Spain (rated AA+) and Portugal (rated AA).’

Isaacs therefore believes it might not be long before traditional, risk-averse UK gilt investors wean themselves off their Treasury fare, and warm to corporate bonds. ‘This is already happening in the case of Greek government bonds. Investors now need to ask whether they should lend money to the Greek government for five years or, for a very similar yield and maturity, whether they should buy euro-denominated bond issues from Vodafone, Carrefour, BHP Billiton, Deutsche Telekom or Diageo,’ he says. ‘If the UK economy deteriorates much further, then there is no reason that the same thing can’t happen in the UK.’

Others are already thinking the same way. Adam Cordery, manager of the Schroder Corporate Bond Fund, believes that UK companies’ preference for rebuilding their capital, rather than spending money they don’t have, will make their bonds more attractive than the government’s. ‘Dividend cuts and rights issues mean more cash and a bigger equity cushion to support bondholders,’ he points out.

But, perversely, the government’s recent decision to spend money that it doesn’t have — by printing more of it — may deliver a short-term uplift for gilts. Though ‘quantitative easing’ may sound more like a remedy prescribed to Super Size Me film-maker Morgan Spurlock after his 30-day fast-food diet, it is actually the government’s remedy for bringing down the cost of long-term borrowing by raising the price of gilts. Up to £150 billion of new money will be created by the Bank of England — three times the value of all the physical coins and notes currently in circulation — to buy gilts and other bonds currently held by financial institutions. These institutions, replete with the sale proceeds, will then have more to lend.

As Stuart Thomson, economist at Ignis Asset Management, explains, ‘The aim of quantitative easing is to drive down future interest rates, represented by risk-free gilt yields, in order to encourage risk appetite.’ So much for the theory. In practice, it has already led to a gilt-buying spree. On the day of the announcement, government bond prices saw their biggest one-day surge in 17 years, and yields — which have an inverse relationship to prices — fell at one stage by 50 basis points.

‘That represented a one-day movement in price of around 8 per cent,’ notes Chris Iggo, chief investment officer for fixed income at Axa Investment Managers: ‘Who said bonds were boring?’ Another City fund manager told the FT, ‘I am not sure if I’m going to want to sell my gilts when I’m pretty certain prices are going to rise, precisely because the Bank of England is buying such a large amount.’

However, a gilts binge may eventually cause the appetite to sicken. Iggo is already feeling bloated. ‘Once the BoE has stopped buying and yields are incredibly low, in my opinion the market will probably only have one way to go — pencil in a government-bond bear market for some time during 2010-11.’

Corporate bonds should remain more palatable, though, for two reasons. If the Bank of England buys up all the gilts, there will potentially be a ‘crowding in’ of private capital into other assets such as corporate bonds and equities, which will in turn benefit their prices. But even if corporate bond yields fall as a result, they are still likely to be higher than gilt yields — providing a return with more chance of outstripping the inflation brought on by printing money. ‘Either way, I believe corporates will beat governments,’ reckons Cordery. Outside of the CDS market, or the McDonald’s Drive Thru, there aren’t many places you’ll hear that these days.