From Gerd Kommer and Jonas Schweizer
Due to the historically low interest rate level in Germany, private investors, driven by their financial advisors or the media, have increasingly shifted their existing investments in safe government bonds or overnight funds into “higher-yield” investment forms within the statutory deposit protection scheme since around 2014. One of the asset classes that is often mentioned as a higher-yield alternative in this context are corporate bonds from large, medium-sized or small companies. In the context of the general public debt discussion, quite a few private investors even consider government bonds to be a questionable asset class because they are too risky.
In order to fully understand the implications of a shift from comparatively safe government bonds into less safe corporate bonds or bank deposits (i.e. bank debt), which is often highly problematic from a risk perspective, it is helpful to look at the principle of sovereign ceiling. It states that companies, including banks as debtors, almost always have to have a worse credit quality (credit rating) than the “home country” of the company or bank for structural reasons.
The “Sovereign Ceiling” is a cornerstone of the creditworthiness analysis of corporate bonds (the “Sovereign” = state, “Ceiling” = ceiling) by rating agencies and bank credit departments. The sovereign ceiling principle states that corporate bonds cannot actually penetrate the rating “ceiling” of the government that hosts the company. That means that the rating of the corporate bond is at best as good and usually worse than that of the country in question. In this context, two conceptual clarifications are necessary: (a) The “hosting” state means the country in which a company develops the largest individual part of its economic activity and in which it typically has its headquarters - in a sense, the company's “home state”. (b) If corporate bonds and bonds of the host state are compared with each other in terms of creditworthiness (expressed in the rating of the bonds), it is always assumed that these bonds have the same currency and the same term.
Companies in developed countries that have a better rating than the country in which they are headquartered can be counted on few hands worldwide, and almost all of these rare exceptions are only one rating level (a “notch”) better than their home country. With around 25 rating levels, this is a negligible advantage - especially in the upper rating levels. If a state's bonds experience a rating downgrade, the same thing happens shortly afterwards to the corporate bonds domiciled in that state. This can actually only happen if the company's rating was already significantly worse than that of the state. An example: If the Federal Republic of Germany were to "go down the drain" in terms of creditworthiness, then it would be a miracle of biblical proportions if BMW bonds, which have always had a noticeably worse rating than the bonds of the Federal Republic of Germany, could remain in the A+ range (four levels below the DE state rating), where they are currently located; Not to mention bonds from banks or smaller companies. They would all turn south in the convoy with the rating of the sovereign.
When government bonds in Ireland, Portugal, Spain and Italy lost their previous ratings in the AA or AAA range during the Great Financial Crisis around 2008, the previously poorer ratings of even the most creditworthy companies within these countries fell at the same time and to the same extent. An example are the bonds of three major Spanish companies BBVA (bank), Iberdrola (energy) and Ferrovial (construction). Their creditworthiness collapsed parallel to that of the Spanish state. Until December 2008, Spanish government bonds had a AAA rating from S&P (the best rating). They were gradually downgraded to BBB– (grade 10) by October 2012. Spain now has a rating of A– (grade 7) again. During this ups and downs, the worse or equally good ratings of the three companies always "nicely" followed those of the state.
Why can companies with their bond ratings usually reach the sovereign ceiling not penetrate? First, the state is a much larger, almost infinitely more diversified economic entity than any corporation within the state. (From a purely economic perspective, one could view the state as the sum of all companies in the state.) Secondly, with its economic policy, monetary policy, tax policy, structural policy and its more or less intensive regulation of almost all industries, the state generally determines the framework within which companies are allowed to develop economically, with or without success. The emphasis here is on “within” and “may”. Thirdly, due to the – relative to companies – states Given the steep political and economic power imbalance in their favor, they tap all available sources of money in times of economic distress in order not to go under and thus ensure the survival of the ruling political caste and the community. An example of the state actually making use of this power is what has now probably disappeared from collective memory Burden equalization law of 1952, which imposed a compulsory levy on property owners for over 30 years in order to finance the costs of supporting displaced persons and late returnees, particularly in the form of social housing. Of course, companies can also take similar measures. The economic history of the past 200 years in almost all countries is full of examples of this. In recent years and decades, states - democracies and dictatorships - have brought even large companies such as Google and Microsoft to their knees in dozens of well-known cases. Fourth, the state necessarily receives its main income - taxes - directly and indirectly from companies. The income tax, which is formally owed by employees, is also economically paid from the company's income. In fact, these funds are paid directly by companies to the state as payroll taxes.
One could argue that companies can pass on increased tax and duty burdens to their customers. From a formalistic point of view, this objection is not fundamentally wrong and is also represented in tax textbooks for sales tax, for example, but from a purely economic point of view it looks different: taxes and duties increase the prices that end customers have to pay and therefore, all other things being equal, reduce demand, i.e. the company's profit that would arise in the absence of taxes and duties. Looking at it the other way around: If the tax burden were to disappear overnight, companies would be able to increase their prices and thus their profits and would therefore earn more. It is no coincidence that both consumers and companies are almost without exception against tax increases when it affects them. Therefore: In a market economy, it is the market that decides whether a company actually succeeds in passing on the tax expense to its customers economically, i.e. not just formally. In economically difficult times - and these are primarily relevant here - this transfer often does not succeed.
The sovereign ceiling principle is justified and has therefore always been a core element of the rating models for corporate bonds at rating agencies and banks.
The numerically rare cases in which corporate bonds have an equally good or better rating than the corresponding government bonds are for the most part only apparent exceptions to the principle of sovereign ceiling. If you take a closer look at the few “better than your home state” companies, it often becomes apparent that the principle of the sovereign ceiling has not really been broken. A simplified example: A company has 60% of its assets (assets) in its home country X and permanently generates around 60% of its sales and 30% of its profits there. The remaining assets are located in country Y and both the remaining sales and the remaining profits are generated there. The company in question has a bond rating of BBB+ (grade 8), while its home state X has a slightly worse rating of BBB (grade 9). Has the company managed to break through the sovereign ceiling? In a technical sense, yes, but only in a technical sense. The company's rating advantage over its home country may result from the fact that country Y has a significantly better rating of AA+ (rating level 2) than the company's home country X. Because the company has 40% of its assets and 70% of its profits in this country with a higher credit rating, the company itself may have a slightly better rating than its home country X. But if you look at this rating constellation from an aggregate perspective, the company has not managed to break through the sovereign ceiling, as its rating is still worse than the weighted average rating of the two countries in which it is active. You would get the same result if you were to mentally look at the two parts of the company in countries X and Y separately and rate them in terms of creditworthiness.
Another apparent exception to the sovereign ceiling principle is the also rare constellation in which the bond rating of a company is better than that of the host state, but the current yield of the bond is also higher. (The current yield is the return from the current date to the maturity of a bond, assuming no default occurs.) This yield advantage indicates that the overall risk of the corporate bond is rated higher by the market - unlike the rating agencies - than that of the government. Why? The higher the expected risk of a bond, the higher its return. The fact that the risk of a corporate bond - despite having an identical or better rating than that of the corresponding government bond - is actually higher can be seen not only from the current yield, but also from its so-called credit default swap spreads. Credit default swaps (CDS) are credit default swaps for bonds and an alternative method of measuring the risk level of a bond. However, CDS only exist for a minority of all corporate bonds.
Companies that are predominantly owned by the state or guaranteed by it are no exception to the sovereign ceiling principle, since the state and the company are essentially one.
The few remaining real exceptions to the sovereign ceiling principle occur predominantly in emerging markets, where both governments and companies have weak ratings in the so-called “non-investment grade” range from the outset (ratings from BB+/Ba1 and below). In other words: In these cases, the government rating is bad and the company rating is slightly less bad.
Overall, one can say: Most of the not very numerous exceptions to the principle of sovereign ceiling are bogus exceptions or refer to the rating ranges far below where one cannot speak of “solid creditworthiness” anyway.
An important implication of the sovereign ceiling principle is that the few corporate bonds in the world that are rated the same or even better than the company's home country are likely to see their credit ratings drop particularly frequently and sharply (i.e. experience price losses) if the home country experiences a rating downgrade.
We only mention here for the sake of completeness that the shares of a company are structurally riskier than the bonds of the same company. This fact is trivial and completely undisputed among experts.
Conclusion
- The sovereign ceiling principle makes it clear that corporate bonds must have a worse credit rating than the bonds of the relevant home country.
- Anyone who has understood the concept of sovereign ceiling will recognize that one should be careful and cautious when considering corporate bonds and bank deposits in the low-risk (“risk-free”) part of a “global portfolio” made up of index funds and ETFs. If you still want to include corporate bonds in your portfolio, you should pay particular attention to broad, international diversification and a short remaining term and ensure that they have at least an investment grade rating. Where these conditions are not met, these investments must be allocated to the risky portion of the portfolio from a risk perspective.
- If the objective is “safety” or “low risk,” stocks are generally not a substitute for bonds, and of course even less so for government bonds.
- Bank balances (i.e. debts of companies with predominantly poor credit ratings) do not generally represent a low-risk form of investment - outside of the state deposit insurance of 100,000 euros per depositor.