Geraldine Lambe analyses The Banker’s Credit Risk 500 and finds the figures add up to a positive picture for corporates and financials as spreads tighten across all sectors.

September ended another good quarter for corporates and financials. While CEOs and shareholders may be smiling, credit investors may have to prepare for leaner pickings for the rest of the year and into the foreseeable future.

The Banker’s Credit Risk 500, using data supplied by Credit Market Analysis (CMA), paints a much more positive picture than it did on its inaugural run in November 2002; then, spreads were still by and large on the way out, whereas this year, spreads across most sectors have tightened to their early 2002 levels or even lower. The market average five-year spread to Libor was 135 when the Credit Risk 500 was constructed in October, versus 215 six months previously. Of the 500, 437 credits’ spreads have tightened by more than 5bp, 41 have widened more than 5bp and 22 are non-movers. The average market move is -80bp on all credits, 60bp for wideners and -101bp fortighteners.

“Generally, corporates are showing an increasing appetite for growth and risk, and M&A activity so far shows that most of the deals have been prudently funded, so spread downside still appears moderate,” says Georg Grodzki, global head of credit research at Royal Bank of Canada. “Company turnaround stories and continued investor demand for credit assets, including collateralised debt obligations, is ensuring a sufficient bulwark against any potential macroeconomic disappointments.”

Autos

In the auto sector, despite the generally positive trend, most analysts remain cautious. In the US, global overcapacity is being compounded by an escalating “incentive” war and putting pressure on prices. So far, European manufacturers have refused to enter into a similar discount competition.

According to the Credit Risk 500, Toyota, whose scope and financial strength should compensate for any exposure to dollar weakness and sluggish US and domestic sales, boasts the tightest spread, at 9bp over Libor. Fiat, the widest spread at 257bp, and increasingly challenged by the advance of Asian manufacturers, was recently downgraded two notches by Moody’s over concerns about its medium-term funding needs, despite its E1.8bn rights issue in July.

“Auto credits are still torn between the sector’s structurally weak fundamentals and investors’ desperate search for yield,” says Mr Grodzki. “The discrepancy between the sector’s best and worst credits looks set to remain wide. For investors betting on a further recovery in the stock market, Ford and GM, both of which are plagued by pension fund deficit, could look attractive despite the seemingly relentless decline of their core automotive profitability.”

 

Chemicals & pharmaceuticals

Chemicals spreads continue to tighten but much of that trend seems to be on the back of the extensive cost and debt reduction undertaken by many companies, rather than because of a positive outlook. Margin pressures look set to continue as the cost of oil-based raw materials threatens to rise following Opec’s recent decision to reduce output levels. Most companies posted downbeat Q3 reports and industrial demand is likely to remain modest, analysts say.

Linde, the most volatile credit according to the Credit Risk 500 (619bp), has a number of underperforming businesses (refrigeration and forklifts) in addition to its more stable industrial gases unit.

Management says it is exploring strategic options on the future of some units, which should help with debt reduction. “But there is still a pretty high risk of a major restructuring where the proceeds are used to improve existing operations,” says a Frankfurt-based credit analyst.

The pharmaceutical sector boasts some of the most robust credit fundamentals. Proposed US healthcare reforms – including the provision of previously unavailable prescription drugs under the Medicare programme – represent an opportunity for the industry. Branded drugs may wilt under the price pressure but increased volumes should offset most, if not all, of the downside.

Aventis (18bp over Libor) is regarded by many as a good pick: its performance has been strong in the past couple of years and it has a promising new drug pipeline. The ratings agencies remain positive and some say the corporate could be looking at an upgrade from its high single A rating if performance continues at this level.

 

 

Retail

None of the corporates included in the 500’s retail selection have widened in the past six months. But still, the retail sector is exposed to a consumption slowdown. Although few commentators expect spending to collapse, most say it will “moderate” in the UK and the US, particularly for “big-ticket” items.

Royal Ahold is on firmer ground since its accounting crisis revealed in February, reflected by the tightening of its five-year spreads from 896bp over Libor to 369bp in the past six months. Disappointingly, new management failed at one of its first hurdles in October when it missed its self-imposed deadline to file form 20-F with its 2002 US GAAP figures with the US Securities and Exchanges Commission. Analysts speculate that the publication of its H1 2003 accounts this month will include plans on disposals, a rights issue and a convertible debt placement.

Leading UK retailer Marks & Spencer – the most volatile retail credit in the 500 universe at 688bp – is consolidating after securing the bulk of its recovery. Its fiscal Q1 2004 sales are projected to be 3.8% up year-on-year but the outlook is subdued, say analysts. “Like some other European retailers, it says the summer heatwave dampened consumer demand,” says Gareth Moody, a credit analyst at CMA.

 

 

Financials

Financials have largely emerged from the downturn, although low interest rates are again heightening margin pressures. WestLB, which was dragged over the coals about the performance and governance of its principal finance unit earlier this year, has seen its senior debt spreads widen by 51bp. The tightest five-year spread is that of BK Nederlandse, whose senior debt is sitting at 3bp below Libor.

Insurance companies have also left the dark days behind them. Most analysts believe that their rebound should continue. Restructuring to de-risk portfolios and inject capital have helped to reduce stock market exposures in many cases. Allianz, whose five-year spread is the tightest among the insurance firms’ at 27bp over Libor, is seen as a stable performer along with much of the rest of the sector.

“Insurance credits have performed in line with their reputation as a leveraged bet on the stock market,” says Mr Grodzki. “However, the sector is still relatively cheap to the banking sector and there is some value left – especially in those names, such as AMP and Allianz, which have re-risked their portfolio as well as bolstered their equity base through rights issues.”

Telecoms

Telco’s H1 results were generally in line or ahead of ambitious guidance regarding deleveraging and earnings. France Telecom looks as if it will exceed its year-end debt targets comfortably and Deutsche Telekom is also well on track to excel in its deleveraging promise, helped at least partly by favourable currency movements.

Mobile players Vodafone and MMO2 boasted revenue growth in the first half of the year, driven by greater price discipline among the established players and the increasing popularity of multi-media messaging.

The only telco in the Credit Risk 500 universe to widen was SBC Communications, which moved from 41bp to 61bp during the past six months. At the other end of the spectrum, Sprint tightened by 310bp, to 136bp over Libor.

“Telecoms offer a classic case of convergence,” says Mr Grodski. “Spread compression has deprived the sector of most of its value plays.

With shareholders becoming more demanding now and event risk possibly around the corner again, the sector should struggle to outperform other sectors from here, although its liquidity and renewed retail appeal should save it from any underperformance.”

 

Branded goods

Branded (or consumer) goods are being challenged by market conditions, as consumers question the extent of economic recovery and keep at least a partial rein on spending. Performance was mixed across the sector in the last quarter, with companies such as Procter & Gamble, Coca Cola and McDonalds exceeding expectations and Cadbury Schweppes and Unilever disappointing.

Although Unilever’s five-year spreads tightened by 12bp, it was the most volatile of the branded goods credits, with a six-month volatility of 810bp, which surprised some analysts. Cadbury Schweppes was also pretty volatile, coming in at 684bp, but tightening by 50bp.

“Unilever is a solid high single A credit, even though it has failed to meet its own sales growth targets,” says Mr Moody. “But the company’s management say they are confident that full year targets will be met. The restructuring programme aimed at concentrating on core brands is progressing well and further disposals are likely.”

 

Methodology

Selection: The aim was to cover the liquid vanilla bond market and incorporate the names that the market regards as benchmarks. Only names for which good and reliable price information is available are used and price information is not taken from small issues, convertible, callable and structured issues. Where companies issue debt from several vehicles or have debt outstanding that was issued before a merger, all the names are used. The database will be expanded in the future.

Calculation of three and five-year spreads: These are calculated by constructing a term structure using spread information from at least three liquid issues of identical creditworthiness and fitting a curve.

Where sufficient bond information is not available, the credit default swap spread and sector indices may be used instead.

Movers: The change in spread over the six-month period is calculated in basis points.

Volatility: The six-month annualised standard deviation of the daily deltas of the five-year spread is a percentage of current five-year spread and expressed in basis points.

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