What is the point of credit research? Is it to provide trading ideas to hedge funds or is it to let traditional investors know if the corporates backing the bonds in their portfolios are about to go bust? Sell-side research houses seem universally to have plumped for the former role, and have been moving away from maintenance research to anticipatory research for some time. But why have they done this? Is it because it is the right thing to do or simply because hedge funds trade more and are prepared to pay for ideas?
There is no doubt that the advent of the CDS market has changed credit research beyond recognition. It has moved away from fundamentals and towards technicals and valuations – inboxes are crowded with comment and analysis on every move the iTraxx indices make. Indeed, it has become far more akin to FX or equity research, focusing on price curve basis movements rather than grinding through detailed numbers on core holdings. And the move from published research to desk analysts at some houses only accelerates this development.
It is not hard to fathom why this change has happened. First, the buy side is now made up of hordes of ex-sell-side traders hungry for trade ideas. There is no way these investors are going to sit down and read a 20-page research report. Secondly, hedge funds want ideas before anyone else and are prepared to pay for them; they need a more intense relationship with the research provider. And it does not take a rocket scientist to figure out that banks will gear their research towards people who a) trade a lot and b) pay for research.
So what is the problem? The problem from the traditional real money investors’ point of view is that most hedge funds don’t make money. There is still a large constituency of investors who do not trade anything like as often as these funds do and therefore don’t necessarily want 20 trade ideas a day. They want detailed information on their core holdings. And as the credit cycle turns and defaults rise, this need will become ever more acute. But these people do not pay (apart from in the bid-offer spread).
As more and more sell-side research is geared away from just this kind of product, real money and buy-and-hold investors could face a growing problem. But so do the hedge funds – even they cannot trade everything every day. They need core holdings too as they face substantial risk if things move against them. This is their portfolio insurance.
Maybe the liquidity of the CDS market means that this doesn’t matter – investors can simply hedge their risk and not care about the underlying credit. But remember Ford, GM, Delphi and Dana? If sell-side research providers continue to focus their product on short-term trade ideas at the expense of underlying credit research, they could be storing up trouble across the board once the market sours and defaults begin to rise.
