Source: www.breakingviews.com is Europe’s leading financial commentary service.
Date: May 2003
The credit research industry ought to be prospering. More European companies have been issuing bonds since the launch of the euro in 1999, and lots of these issuers are now being downgraded by the credit rating agencies. All this points to a pressing need for more insightful analysis. But the industry does not look able to meet this need.
The downturn in credit quality is among the sharpest on record. Look at the crop of euro-denominated non-financial borrowers. More than half of them are rated triple B – the lowest investment-grade rating – or below. At this low level, bonds become extremely volatile. Investors need to know more about what is going on, not less.
But the research industry isn’t expanding to provide this extra coverage. There are signs, indeed, that it may be starting to shrink. There are two main reasons for this. One is that credit research budgets generally form part of wider research budgets, and these are being slashed in the wake of the equity market downturn.
European rating actions
| Source S&P |
Another is that the credit research industry has not responded as fast as its equity counterpart to the regulatory assault mounted on the research business model by New York state attorney-general Eliot Spitzer. At first glance, there is no obvious reason why it should have to. After all, the credit business is less prone to hype than equities. The best credit investors can achieve is getting their money back with interest. It is in equities where the gains are theoretically limitless.
But consider how a credit-research desk earns its keep at an investment bank. Essentially, it is a cost centre. And various parties have claims on its time. These include bankers pitching debt issues to companies, the bank’s trading-and-sales arm, and investors trading. The investors don’t pay the bank directly through commissions, as in share dealing. There is in effect a bundled charge for execution and research that is levied through the bid-offer spread the bank makes on the bonds that it trades.
In some ways, the conflicts of interest inherent in credit research are identical to those in equities. Investors don’t want analysis that may have done the rounds of the trading desk before making its way to them. And they don’t want research that could have been influenced by bankers who are trying to win business from companies.
But that’s not all. Companies have only one equity security while they may have a number of bond issues outstanding. So there is more new-issue-led research than there is on the equity side. That increases the potential for conflict.
Of course, the industry is acutely aware of these conflicts. Some analysts fiercely guard their independence. Analysts are banned from front-running ideas to trading desks. And many banks get different analysts to cover new issues and secondary market business.
Spitzer’s assault might lead to this casual arrangement becoming more formal. UBS last month said that it was splitting these two functions. Part of the Swiss bank’s credit research function is being hived off to investment banking. There analysts will produce marketing-type research to support new issues. As this won’t purport to be independent, the conflict should be eliminated.
But all this raises another question. Who will pay for the remaining analysts? If they are still supported by the sales-and-trading operation, investors may not believe they are truly independent.
Of course, unbiased, insightful credit analysis will command value over time. And less, in terms of me-too research, can be more. But making the transformation won’t be easy. In equities, proceeds from Spitzer’s global settlement on conflicts will help fund the move to independent research. The unbundling of commissions will also help.
It isn’t clear that any of the Spitzer money will find its way into the pockets of bond analysts. And it isn’t easy for banks to unbundle a trading spread.
The investment banks don’t yet seem to have a solution. UBS, which has gone further down the reform path than any other house, used its restructuring as a cover for a huge cutback. It has reduced the size of its credit-research operation by almost 40%. If other banks follow suit, there will be a lot less research, not more, available to bond investors.
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