Stock Market Week: Credit spreads are the best way of gauging market players' nerves
Monday 09 August 1999
For all their electronic gizmos and inverted price/earnings ratio curves, traders and analysts have to resort to rather waffly remarks such as "nobody trusts this market". But what does that mean? Measuring nerves, especially those of as fickle a creature as an equities trader, is almost certainly a thankless task. But there are ways to determine whether market players are really "nervous" and how nervous they are.
One, slightly anoraky, way of taking the equities' pulse is to look at the link between corporate and government bonds. The two have a love-hate relationship summed up by the so-called "credit spread" - the difference between the yields of the two types of securities.
The credit spread is a sort of "fearometer" as it measures the risk of default that investors attach to debt issued by companies compared with the safer-but-duller government bonds. The bigger the spread, the higher the perceived risks for companies. Or to put in pseudo-psychological terms, the bigger the spread, the more nervous investors are about the corporate outlook.
Credit spreads can be a useful indicator of equities markets' malaise as they measure investors' disaffection with companies and, by implication, with their stocks. A rising spread is also a worrying sign for companies' balance sheet as it points to a rising cost of capital. A recent study by fund manager Legal & General shows that after last October's sharp stock market correction, the credit spread soared as markets shunned the ailing companies' paper and sought the safety of Western governments' bonds.
At the peak of its credit crunch, the spread widened from its historic average of around 80-100 basis points to 150 basis points - that is, UK and US corporate bonds had to yield 1.5 per cent above their government counterparts to convince investors to buy them.
Since then, equities have rallied, emerging markets have started to recover and the US economy has extended its Goldilocks run of high growth and low inflation, and the credit spread should have gone back to its normal level as the corporate outlook improved.
However, the spread only narrowed to around 110 basis points, still some 30 points above its recent average, despite the recent spike in US government bonds' yields. The stubbornly high level of corporate paper's yields can be partly explained by a flood of new issues. US and UK companies have been extra keen to tap the debt markets to take advantage of the low interest rates. In the last few months, the debt rush has accelerated as hints of increases in rates and the onset of millennium fear have encouraged companies to raise capital fast.
In July, car-maker Ford launched the largest-ever corporate bond, a jumbo $8.6bn issue and only last week the retail giant Wal-Mart launched a $5.75bn bond to fund its takeover of Asda. On our shores, BT, National Grid, BP Amoco, Orange and Colt have all issued debt.
But increased supply is not enough to justify such a large spread. The credit yield gap is telling us that investors are looking at companies' futures with bated breath and their fears should not be taken lightly.
Fears or not, dealers will have to grapple with a few blue chips results this week.
BA touches down with first-quarter figures today which are expected to show a dramatic slump in underlying profits from last year's pounds 145m to as little as break even. Attention will focus on the airline's plans to arrest the decline including a reduction in capacity and a switch to smaller aircraft. BA wants to focus on more flights to major European destinations and fewer to the smaller cities on the Continent.
BP Amoco reports tomorrow with second-quarter figures. Net income should come in at around pounds 1.2bn, up from pounds 1.14bn last year, helped by the recovery in the oil price and a portion of the predicted $2bn of cost savings flowing from the merger with Amoco of the US. After Shell's sparkling figures last week all eyes will be on BP's refining margins.
BSkyB beams full-year figures on Wednesday. Rupert Murdoch's satellite TV outfits will plunge into a pretax loss of some pounds 254m, compared with a profit of pounds 271m last year. However, the figures will be heavily distorted by a pounds 315m provision for the launch of digital TV and pounds 6m for the aborted bid for Manchester United.
Underlying profits will be around pounds 70m. The market will want an update on the number of digital subscribers. The Deutsche Bank team is going for pounds 725,000 at the end of June, well on track for Sky's pounds 1m target by October. New chief executive Tony Ball will also be quizzed on Open, the company's interactive TV to be launched in the autumn.
CGU, interims on Wednesday, should do better than its rival composite insurer and mooted takeover target Royal & Sun Alliance. Broker Charterhouse is predicting operating pre-tax profits of pounds 409m, up from pounds 399m in 1998. General insurance profits should be broadly flat despite tough conditions in the UK motor market. However, life profits should grow in double-digit thanks to good performances in Europe. CGU's position in the saga of the French banks will be a key issue. Last week, the UK group's decision to up its stake in Societe Generale - whose merger with Paribas has been thwarted by a hostile bid from BNP - was halted by the French judiciary.
Life assurer Sun Life & Provincial, on the block on Thursday, should also please investors with a near 17-per-cent rise in interim operating profits to pounds 142m. Strong growth in premiums should offset any dilution from the acquisition of Guardian Royal Exchange. The management will also be grilled on recent rumours of another UK strike by Sun Life's French parent AXA.
Other major companies scheduled to report include Saatchi & Saatchi, the advertising agency which is expected to announce half year profits up from pounds 12.4m to pounds 14.6m; Smith & Nephew, the healthcare group, is forecast to report a jump in half year profits from pounds 71m to pounds 85m.
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