Government and bank debt is the problem, not the solution, writes Christine Johnson. If you want safety, follow the money - to large corporates

In the past, investors looking for safety moved first to banks and, when things got really bad, into governments. Is it time to stop rushing for refuge into burning houses? The evidence would suggest that the ‘real economy’ - large businesses with a manufacturing base or a meaningful service offering - is most likely to provide reliable real returns over the longer-term.

The concept of ‘risk free’ ended on 5 August 2011 when S&P downgraded the government debt of the US. Now everything is a credit: every debtor needs to be judged on its merits.

Core sovereign bonds - as issued by the US, UK, Germany, Japan, France - performed strongly in 2011, despite fundamental measures such as net debt to income or income security suggesting little, if any, value. They performed for two reasons: a legacy reputation as ‘safe-havens’ in a market where investors needed to move quickly; and the tight sellers’ market created through massive quantitative easing (QE).

No one expects the core sovereigns to default in the short to medium term but, given their vast indebtedness, there is clearly significant political risk - evidenced in the failures of the US Congressional ‘super committee’, the UK’s struggle to reduce its deficit, and Germany’s recent failed bond auction. In return for the ‘safety’ of their bonds, core governments offer low to negative real yields. Japan is the only major state still paying a positive real yield, and it has public debt at 230% of gross domestic product.

Don’t bank on it
If there is no more ‘risk free’, a meaningful number of banks, certainly in Europe, are already insolvent. In the last round of European Central Bank stress tests, banks were allowed to count as capital non-Greek sovereign bonds, at nominal value. Real time prices tell us every moment that that is not true for Italy, Spain or France, nor even, now, for Germany. This is quietly changing the way fixed-income markets operate. A week before the German government bond auction, Banco Santander tendered for a tier-two bond issue. The terms were draconian. By my calculation, investors would have to forgo a 25% total return from the previous day’s price to the earliest call date. The alternative was to be left with a piece of paper paying 1.4% over Euribor until 2017 - in other words, close to nothing.

The suspicion spread that Santander faced ‘problems’ unknown to the market. The Association of British Insurers threatened legal action. Santander threw its reputation to the wind to save an amount that would have little impact on its balance sheet.

Like the US downgrade, the Santander deal is emblematic of a much wider sickness. States own bank equity and banks own state debt. Banks depend on the state, by way of monetary authorities, for their liquidity. They might not admit their poor solvency, but they have all but ceased lending to each other.

Since the collapse of Dexia, banks have queued to make their bondholders offers they can’t refuse. It is being called ‘liability management’ but it is a form of default. The rules that once applied are no longer relevant. Once the state is involved, regulation can be re-written, as can the law. Where politics is concerned, etiquette is brushed aside.

Back to the real economy
A revealing exercise is to compare the US and Jaguar Land Rover (JLR). Look at the numbers: why is the US a safe-haven while JLR is rated ‘speculative’ by both Moody’s and S&P? And why is JLR, and many other similar companies, in such an apparently good position when the rest of the economy is so evidently struggling?

A significant proportion of the current public debt in the UK and the US results from the massive bailouts of 2008 and 2009. The purpose was to avoid recession, sustaining employment at a level thought to be the minimal necessary for political expediency. Since then, central banks have assumed responsibility for interest rate risk, keeping yields low through QE, in the process hugely expanding their balance sheets and adding to the gridlock besetting what has become a political-financial debt complex. Banks, the supposed beneficiaries, in fact became entangled in public debt and have now been forced into a process of aggressive re-capitalisation and re-regulation. This leaves them with little flexibility to lend to their own clients - individuals and small and medium-sized businesses.

Large companies such as JLR, by contrast, which don’t need banks because they can access capital markets directly, have found themselves in an exceptionally good position. Protection from recession risk has brought default rates to historic lows, with the best forecasts indicating that they are likely to remain at below average levels. Interest rate protection has ensured that their cost of capital is negligible. The result, as we see, is strong free cash-flow and an accumulation of substantial spare capital.

And yet investor sentiment and political expedience have combined to ensure that while absolute yields are low, spreads are historically wide. For those investors prepared to take on the supposed risk of corporate bonds, the result could be excellent absolute and relative returns, with a fair ‘margin of safety’ - safety reflected in financial accounts rather than political promises.

Other than under the somewhat broad rubric of ‘real economy’ there is no simple definition of these companies’ defining characteristics. They are unlikely to be dependent on home market consumers, such as high street retailers, but they include domestic businesses, such as cable companies Kabel Deutschland or Virgin Media, supplying broadband services increasingly considered essential.

In many cases, they have been able to move operations to low-cost economies while focusing their marketing on those with the highest growth. They also include companies such as JLR or BMW whose home markets are relatively resilient to economic stress. They certainly include companies like LVMH, which is able to provide a low level access to ‘luxury’ goods. Others might be CNH, which makes agricultural machinery, Smurfit Kappa, the packaging business, or Kuka, a German machine-tool maker. They also include what might be characterised as ‘survivors’ - companies with the products, revenues, assets, credit, management and strategy to weather even the most extreme economic crises.

As strategic investors, we understand that fundamentals are not always the primary drivers of asset values. QE might be an artificial distortion that will eventually need to be abandoned - but it is a reality while it lasts. Sentiment may or may not be well-founded, but it ultimately determines what investors will pay for an asset on any particular day. We also know the truth will out and that, at some point in the future, fundamentals will come back into the foreground.

Christine Johnson is the manager of the Old Mutual Corporate Bond fund at Old Mutual Asset Managers