STOCK MARKET WEEK: CREDIT SPREADS ARE THE BEST WAY OF
GAUGING MARKET PLAYERS' NERVES
independent.co.uk
ALL IS not well with the stock market. The big
tumbles, increased volatility and general sense of
unease seen in recent days cannot just be
ascribed to the traditional bout of summer jitters.
Anyone with a trading position in the Square Mile
will tell you that the market is "nervous" and
people are "sitting tight" until the storm is over.
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. |
