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Marc Pinto, head of high-grade credit research at Merrill Lynch, recalls taking part in a roadshow in the US last year for a tier-one capital-raising issue from a European bank. Merrill Lynch was co-arranging the deal with another firm. Pinto’s job was to discuss the credit strengths and weaknesses of the bank with potential investors.
During the roadshow, bond spreads started to tighten to such a degree that Pinto felt there was no more left to go. “I just felt that the bull run in tier-one credit spreads had come to an end.” He quickly put out a research note to investors saying as much.
It was not the most helpful note for the debt capital markets team running the deal. “The bankers at the co-lead were particularly angry.” But Pinto is unapologetic. He says: “Our role is to be objective. People are used to speaking their minds here.”
Analysts at Merrill Lynch report through a global head of research to the firm’s executive board and are not directly answerable to other business heads. The Merrill investment banker running the deal wasn’t overjoyed either but he shrugged off the report. Pinto recalls: “He rang to talk it over and said ‘OK, fair call.'”
It turns out, Pinto’s call was spot on.
The head of credit research at every firm in the business has similar war stories to tell. None of them likes writing new-issue research. It’s time-consuming and it often distracts analysts from other work that bond investors might derive more benefit from. What’s more, it raises unwelcome questions about the true independence of credit research analysts. Are these reports really meant for investors, are they designed simply to sell the bonds or are they just buttering up to issuers?
The reputation of equity analysts across the industry has been tarnished by their eagerness in 1999 and 2000 to promote every lousy dot com whose initial public offering their firm was leading. Every week brings a new announcement from an embarrassed equity firm. Analysts cannot own stock in firms they cover (some think they should be forced to); they must issue an equal number of buy and sell recommendations; they must publish opinions on how stocks will perform relative to their sector.
Credit analysts don’t want to see their own credibility destroyed in the same way. Oddly, no-one raises the issue of analysts’ independence from traders and salesmen who might be tempted to front-run their recommendations. It seems to be widely accepted that analysts must talk to traders and salesmen to gauge market technicals and sentiment and inform their relative value calls.
Just mention new-issue research, however, and most analysts just roll their eyes.
“You absolutely cannot compromise your reputation, because it’s all you’ve got,” says Anja King, managing director at Deutsche Bank. “So you have to put your foot down. You have to lay out the negatives and the positives and when investment bankers or the company ask you why you’re writing such things you have to answer: ‘because they represent my unbiased view’ or ‘because they’re true.’ Companies are welcome to try to change your opinion by providing more facts or information, but if not you have to stand by your opinion. I spend a lot of time fighting for our analysts’ views.” King, who covers telecoms, recalls writing a report at the time of a new issue for France Telecom on which Deutsche was a co-arranger in which she indicated the company – and other telecoms – could be downgraded from the single-A to the triple-B category if it did not meet the rating agencies’ expectations for timely debt reduction. It wasn’t a popular line but eventually it was proved to be right.
Even a feisty character such as King accepts that analysts working at firms that are very active in the primary markets have to acknowledge that fees from those deals help pay their salaries. She says: “Let’s get real: you’re never going to really blast an issuer you’re leading a deal for. You will provide all the relevant information and a more balanced view but allow the investor to draw his or her own conclusion – which they usually do, because they understand the sell-side dilemma. Investors are learning to read between the lines.”
The head of credit research at another firm explains how he calms down his own analysts when pieces come back from an issuing company – they’re sent to issuers for fact checking – with recommendations to change the editorial content. “What I say is: ‘Don’t get upset by changing a phrase here or there as long as you manage to convey an accurate overall picture of the credit.”
Investors know to check the lead manager’s research against that of other firms not in the deal. Meanwhile the benefit for an analyst of working at a successful bond arranger is that he or she can obtain much better access to company managers, a much better sense for how they think and how their companies work. Conveying these findings to investors in new-issue research can be a real art form.
A head of research recalls commending the management team of one company for having successfully integrated a number of aggressive acquisitions and observing that it would no doubt continue to play to this strength. The management team was flattered. Investors read the warning. Making acquisitions, especially leveraged ones, is a big minus for credit investors.
Another head of research regularly calls investors to check that they have successfully read between the lines of new-issue pieces. An observation that a company might be attractive to a range of buyers might be code to watch out for the company being subject to a leveraged buy-out and downgraded. “I’ll ask: ‘Was it clear what I was getting at.’ Often they’ll say: ‘Oh yes, it was painfully clear’.”
But analysts from one firm at least have no stomach for such games and pretence. “We don’t write general new-issue research and haven’t for quite some time,” says Said Saffari, head of European credit research at CSFB. It’s a policy that Saffari agreed with John Romanelli, CSFB’s head of European debt capital markets. Rivals sneer that it merely reflects how far CSFB has fallen down the bond league tables. But it has gained some recognition for its stance. Respondents to Euromoney’s 2002 credit research poll were asked to nominate the most independent and objective team. These questions attracted few votes – but CSFB topped the category.
Saffari says the policy has not hurt the firm’s primary business and throws the criticism back. “We go into deals all the time and have to read these long polemical pieces from the other underwriters which on some occasions can undermine our efforts at self-governance.” Saffari adds: “We’re very comfortable with a direct analyst-to-investor dialogue and company one-on-ones and I had hoped that some other firms would have followed us. I think our approach protects the credibility of the credit analyst’s profession at a time when we should be trying to establish our legitimacy as beyond reproach with all the current integrity issues.”
It’s a sentiment that will have analysts at many firms that continue to pump out new-issue research quietly and grimly nodding their heads in agreement. So why do they still produce new-issue research? “Quite simply, many clients want it,” says Catherine Gronquist, head of credit research at Morgan Stanley. “If for whatever reason – perhaps because a deal has come together quickly – we launch an issue without it, investors communicate their displeasure.”
Different firms have come up with their own rules for new-issue research in an effort to codify their independence. “We went through a long process with our analysts, our debt capital markets people, compliance, the commitments committee and our special execution group,” says Donna Halverstadt at Goldman Sachs. The firm came out with guidelines and a couple of key rules. “One of those key rules is that we have to show balance and talk about the credit concerns as well as the credit strengths. Another of the key rules is that we cannot make relative-value calls in new-issue research.”
The varied approaches to writing new-issue research – some firms email it out to all and sundry well in advance of an issue, others present numbered hard copies to select qualified investors just before launch – highlight a regulatory blind spot in Europe. Investors may be sceptical about a lead managers’ research on an issuing client but they need it because European bond deals are not always accompanied by red-herring prospectuses.
Most heads of research wish they were. Then they could rein in their new-issue output. Indeed they would have to restrict themselves to brief internal memos for their sales forces. Publishing new-issue research might open firms to legal liability if they contain different projections from those the company officially presents in the red herring. “We need an SEC for Europe,” says one banker. “Right now, even a regulator like the FSA has no clue about all this.”
