The picture is not one of a general and sustainable recovery in corporate earnings. Most economists expect the US, Japanese and UK economies to slow, if not stall, next year. With a mixed start to this corporate earnings season – best illustrated by General Motor’s numbers – things did not improve for credit investors when the New York State attorney general, Elliot Spitzer, launched his latest initiative, this time concerning long-standing “business allocation” practices in the commercial insurance industry. And this is against a backdrop of bad news in the pharmaceutical sector from Merck and Pfizer, and continued mixed signals from retailers on both sides of the Atlantic.
The Banker’s Credit Risk ranking, now in its third year, has been expanded from 500 credits to 1000. The listing, based on data from Credit Market Analysis (CMA), is the only one of its kind: CMA’s mapped database of bond spreads, credit default swap rates and fitted term structures allows unique, least derived analysis that provides the best possible measure of each issuer’s credit risk.
The list was constructed on September 29 and shows the spread movement between that date and six months previously. However, to reflect the events in the insurance sector, we updated insurance figures on October 20. Insurance volatility aside, the list shows that, as last year, spreads have continued to tighten pretty much across all sectors. Of the 1000 credits, only 223 have seen their spreads widen. How much tighter can spreads possibly go?
Utilities
In the utilities sector, analysts see few catalysts ahead that could derail the tightening train before the end of the year – or even into 2005. Neil Beddall, director of credit research at Barclays Capital, says: “There has been little issuance from utilities this year – about €12bn compared with €29bn last year – but investors have been looking to invest.
“This has helped to push the price down on a scarce resource. Many investors now see utilities as a safe haven for money – they’ve gone through restructuring and ratings are pretty stable. There have been no shocks or M&A activity to push spreads out,” Mr Beddall observes.
Financial institutions
In the financial institutions sector, firms are generally making more money this year than in 2003 and, again, investors have money to put into the sector. Additionally, rating for rating, analysts reckon that financial institutions offer a pretty good return vis-ŕ-vis non-financials. Banks have tightened on average by 21.6% in the past six months.
“Looking forward, credit spreads will be a function of positive technical factors and sound fundamentals, offset by historically tight spreads, which means that break-even returns are not attractive,” says Nigel Myer, director of credit research at Dresdner Kleinwort Wasserstein. “2005 is likely to be the result of the balance of power between these elements together with whatever happens in the collateralised debt obligations market,”
But in the insurance sector, the spreads have really hit the fan. Following the New York State attorney general’s suit against Marsh & McLennan, the company’s spread widened by a massive 792.9%. AIG has moved out by 34%. Investors fear that Mr Spitzer’s latest probe will escalate into a major overhaul of the conduct of insurance brokers, not to mention some hefty fines and changes of strategy.
Telecoms
Deutsche Telecom – at 574 in our list, with a spread of 42 over Libor, tightening by more than 25% in the past six months – announced last month that it will spend €2.9bn in cash to buy out its ISP business, T-Online. While it can finance this from its own balance sheet, the news was an indication that the de-leveraging process that has characterised the telecoms sector is coming to an end. Credit investors should not expect too much further tightening of spreads just yet, however.
Julie Lamirel, credit researcher at Lehman Brothers, says: “Lehman Brothers’ equities research has also started factoring in a share buyback for Telecom Italia, representing €2bn in 2005 and a further €2bn in 1006, arguing that [the company] is more likely to want to satisfy shareholders rather than Moody’s. Hence the shift of focus from bondholders to shareholders is effectively materialising. And, while the impact is manageable – not yet a re-leveraging story – it does mean, in our view, that the upside to spread levels is limited.”
Oil and gas
Oil and gas companies are riding high on prices amid operating environments that are often difficult. Of the 59 firms in our oil and gas universe, only six saw their spreads widen.
Some investors are being forced to go down the credit curve to generate yield. “Higher quality names are trading at such tight levels that it is difficult for us to get excited about them at the moment,” says Tom Lyons, executive director, European credit research at UBS Investment Bank. “This has, for some time now, been driving investors to depend increasingly on riskier credits, such as Repsol, for energy sector exposure. LatAm exposure, a primary risk to Repsol’s credit profile, presents no urgent near-term problems but we think it will be a recurring source of volatility.”
Mr Lyons says that oil and gas is a defensive sector. “High oil prices are allowing even higher-cost companies to reduce debt,” he observes. As a caveat, he believes that it is important to remember that many companies are seeing rising operating and capital costs. “Also we are monitoring companies’ expansion plans,” he says, adding that he is not overly concerned about the risks, however. “The three-month credit outlook is relatively stable for European investment grade energy issuers.”
Autos
Ratings risk remains the major factor for credit investors in the auto sector. The big three ratings agencies made their concerns known last month when Moody’s placed GM on review for a possible downgrade, then Fitch downgraded the company from BBB+ to BBB with a negative outlook the following day, and finally Standard & Poor’s (S&P) downgraded it to BBB- with a stable outlook but affirmed the BBB- rating of Ford and maintained its stable outlook.
The downgrades will focus the market’s attention on negative industry trends, and some investors may ask whether they should be structurally underweight these names. But the framework for the decisions was well documented and most analysts believe the spread reaction should be contained.
Alan Capper, head of credit strategy at Lehman Brothers, says: “We regard these developments, although initially negative for GM during the past week, as positive for GM and Ford in the coming weeks. By late Thursday [of the same week in which the ratings actions were carried out], GM had already retraced some of its recent underperformance. Ratings agency action has lifted some of the uncertainty, and fears over more penal action have proved misplaced for now.”
Emerging market sovereigns
Putting aside the spread increases of Panama, Columbia and Peru (210.5%, 199.9% and 145.8% respectively) emerging market sovereign debt’s tightening spreads reflect the high demand that is the result of a unique confluence of cyclical and structural conditions in the global economy and in those of many major emerging markets. Supply has failed to keep up with the significant demand for high-yielding credits.
“Although EM sovereigns are issuing more debt than in recent years, some major countries are issuing less external debt: fiscal deficits have been reduced and financing has been shifted into local markets,” says Arnab Das, head of emerging markets research and strategy at Dresdner Kleinwort Wasserstein.
External deficits have also been reduced and current account financing has been shifted to foreign direct investment. “Russia, for example, has been paying down debt since 2000 and Mexico has been shifting its entire deficit financing into its domestic market and has, at most, refinanced external debt. Many other sovereigns, including Brazil, have been essentially rolling over existing debt rather than increasing issuance on a net basis,” says Mr Das.
Global financial market conditions are exceptionally favourable for EM economies at present. US growth is slowing in an environment of easy monetary conditions – cheap money in the US and EU, and free money conditions in Japan. Yet, growth is still high in China and other major commodity/energy importing countries. As a result, in general the balance sheets of EM countries, which are typically exporters of energy or other commodities and have dollarised liabilities, look good.
There are risks, though. If recession materialises in the US and spreads through the world, it would be a serious risk for financial markets, and for EM economies in particular. Negative growth or a serious increase in fears of recession would hit energy and commodity prices pretty hard. “But our core view is for deceleration in both growth and inflation – not a recession and not stagflation,” says Mr Das.
Methodology Selection: The aim was to cover a broad selection of credits traded in credit markets. Calculation of five-year spreads: CMA collects data on both the bond and the credit default swaps (CDS) market, which it then maps into issuer-currency term structures. Term structure analytics are used to create the CDS rate and bond spread term structures for each issuer, such that 1-10 year marks are available for each name in bond and CDS markets. Where available, the actual five-year CDS level is represented. Cases for which no CDS market was available are then “stepped down the derivation” scale, testing recent historical CDS rates and then the asset swap spreads of the credit bond term structure. In these cases, the CDS rate is implied using the asset swap spread information coupled with average sector basis information. For a full explanation of the derivation process, please go to www.creditma.com.
Movers: The move is calculated as the difference between the current spread and the spread six months previously. It is shown in percentage points and basis points.
Liquidity categories:
1) very liquid market;
2) liquid market;
3) average tradable credit risk – trades actively in the market, but deals may need to be negotiated by appointment;
4) less liquid – transactions less common, estimated trading every two to three days on any market or maturity.