How many analysts do you need?

The large number of fallen angels – formerly investment-grade credits that have fallen to non-investment grade – has led many firms to consider merging their once separate investment-grade research teams with their high-yield colleagues. In Europe the two markets have been almost entirely distinct, with different buyers and few of what are called cross-over investors operating in the middle ground populated by rising BBs and falling BBBs. As a result, some valuable investing opportunities have gone begging.

Chris Francis, head of international credit research at Merrill Lynch, says: “Certain investment-grade bonds have offered far wider spreads than those on lower-rated bonds in the same sector held in high-yield investors’ portfolios.” Merrill has concluded: “We don’t want to define analysts by who the end buyers are but by our own expertise. If you’re an expert in, say, transportation, it’s important that you be able to make relative-value calls across the markets.” Francis adds: “High yield and investment grade used to operate in silos, perpetuating the myth that they were entirely distinct. High-yield analysts missed how cheap certain investment-grade credits were trading at a time of huge demand among high-yield buyers for anything outside the TMT sector.” Merrill Lynch addressed this in the fourth quarter of last year.

JPMorgan has also merged its high-yield and investment-grade teams. “We see the market as a continuum, even if the investors are distinct,” says Emmanuel Weyd, vice president at JPMorgan.

“In some sectors, such as chemicals and steel, we can add a lot of value by doing high-yield type analysis of BBB-rated names. As well as providing more in-depth research we have a dedicated trader covering 25 or so of the most interesting cross-over names.”

Heads of credit research at other firms see the potential of the cross-over market but question the decision to merge coverage. Is it just cost-cutting in a bear market for investment banking dressed up to look like something clever? “This is particularly topical right now as investors are very focused on crossover companies,” says John Fusek, executive director at Goldman Sachs. “It is partly driven by what accounts are doing and partly by our desire to look at these situations from as many points of view as possible. We are doing more joint reports with high-yield and investment-grade input and hosting investor conferences with investment-grade, high-yield and equity analysts.” But the firm hasn’t merged teams because the markets and the investors are still largely different.

The halfway approach is simply to be more disciplined in handing over coverage of a fallen angel to a high-yield analyst. Said Saffari, head of European credit research at CSFB, says: “We collaborated with the high-yield analyst on Invensys for example, long before it was downgraded.” But coverage hasn’t merged. “There are still far too few cross-over names.”

Could there ever be a more radical merger of debt and equity research disciplines. Most credit analysts of course, decry any such notion. Might cost-conscious senior managements not be tempted to merge coverage? “Is it a fear that I might have to report to an equities person? Not if it was more productive for our clients, motivated cross-fertilisation of ideas and cut costs,” says Saffari. “Equity research has fantastic resources that credit analysts can utilise, learn from and improve their knowledge base. My team has been able to expand the scale and scope of our analysis greatly through regular and interactive dialogue with our equity counterparts. But to fully merge credit and equity research, you’d probably have to also consider the structure of sales, trading and primary debt operations as well.”