A potential purchase of a stake in Qantas Airways Ltd. by the Australian government may spur a rally in the carrier’s debt as the move would boost support for the company’s investment-grade credit rating.

The government is considering buying as much as 10 percent of the Sydney-based airline to provide it with an implicit credit guarantee, the Australian Financial Review reported today, citing people familiar with the matter it didn’t identify. The cost of protecting the company’s debt against non- payment could drop to a level unseen in almost 2 1/2 years, according to Deutsche Bank AG.

Qantas, privatized in 1995, may post its second annual loss in 20 years as it faces rising competition on domestic routes from Virgin Australia Holdings Ltd. Qantas Chief Executive Officer Alan Joyce has urged the government to help the carrier compete more equally with Virgin, which is planning a share sale that could bolster the stakes of its foreign backers including Etihad Airways PJSC and Singapore Airlines Ltd.

“Favorable comments by government and opposition leaders already provide a degree of implicit support to the credit, in our view, reducing the risk of a rating downgrade if operating conditions deteriorate further,” Gus Medeiros, a Sydney-based credit strategist at Deutsche Bank, wrote in a note to clients today. He said the company’s credit default swaps could drop as low as 160 basis points and recommended investors take a long position on the credit.

Qantas CDS

The cost of Qantas CDS, which investors buy to protect themselves against the risk of non-payment, fell 7 basis points yesterday to 202, according to data provider CMA. The last time they were as low as 160 basis points was in June 2011.

Qantas’s shares have dropped to A$1.22 as of the close today in Sydney, down 18 percent since Dec. 31. The stock rallied 4.7 percent this week. The benchmark S&P/ASX 200 index has risen 14 percent this year, while Virgin Australia has fallen 6 percent.

Australian Treasurer Joe Hockey yesterday mooted the possibility of lifting legislative restrictions that cap foreign shareholdings in Qantas to “level the playing field.” Other options include a direct guarantee, direct low-cost loans and a government equity purchase.

Hockey declined to comment on the Financial Review report at a news conference in Sydney today. Qantas said in an e-mail statement that the company has been discussing with the government the challenges it faces and “a range of policy measures” that would assist the airline.

Virgin Australia CEO John Borghetti said today that any measures offered to Qantas by the federal government should also be offered to his airline.

Three Shareholders

Qantas’s Joyce called on staff in an e-mail Nov. 18 to lobby politicians against the share sale by Virgin, which could push foreign airlines’ holdings of its stock as high as 70 percent. Brisbane-based Virgin’s three airline shareholders have promised to buy as much as A$220 million ($200 million) of new stock through the capital raising announced Nov. 14. That’s providing the airline with funds for a market-share battle that had previously left it short of cash.

Opposition transport spokesman Anthony Albanese said in an interview with Australian Broadcasting Corp. television yesterday that he wouldn’t back a change to the law and favored “perhaps a small equity take up by a government entity.”

Joyce has forecast Qantas’s yields will drop to their lowest level since at least 2003 as a result of domestic and international competition. Analysts have cut their estimates of Qantas’s full-year net profit by A$193 million since Virgin announced it had taken a A$90 million loan from its major shareholders Aug. 30.

Net Debt

Qantas had A$4.8 billion of net debt as of June 30, the company said in its annual results. It finished the financial year with A$2.8 billion in cash and A$630 million in undrawn standby and revolving debt facilities.

The cost of protecting Qantas debt against non-payment has fallen 41 basis points this year, the fourth-best performer among the 25 members of the Markit iTraxx Australia gauge of CDS. The CDS benchmark has dropped 27.5 basis points to 100 over that period.

Qantas, Southwest Airlines Co. and Deutsche Lufthansa AG are the only three carriers globally that have investment-grade credit rankings at Standard & Poor’s, while only Southwest and Qantas carry non-junk scores from Moody’s Investors Service. Qantas is rated one level above speculative grade by both.

The yield premium over Treasuries on Qantas’s $514 million of 2016 U.S. dollar notes has fallen 145 basis points this year to 195 basis points, according to BNP Paribas pricing. The spread over the swap rate on the carrier’s A$250 million of 2020 Australian-dollar bonds has dropped to 240 basis points from 295 at the time the line was first issued in April, Bloomberg prices show.

Editors: Vipin V. Nair, Chris Bourke. To contact the reporter on this story: Benjamin Purvis in Sydney at bpurvis@bloomberg.net. To contact the editor responsible for this story: Katrina Nicholas at knicholas2@bloomberg.net.

Photo Credit: A ground crew member cleans the windshield of a Qantas passenger plane at Adelaide airport in this February 13, 2012 file photo. Tim Wimborne / Reuters