Banks that have downgraded client-directed credit research might well be short-sighted. Euromoney’s latest credit research poll indicates that some of the top-ranking banks have recognized this, taking a ‘third way’ that allies trading desk focused research with a sustained published research capability. Jethro Wookey looks at the trends behind the latest results.
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THESE ARE NOT the halcyon days of credit research. Many houses have downsized the importance of research as part of cost-cutting measures against a backdrop of a prolonged credit bull market. Even those that remain committed to providing a comprehensive service are being forced away from traditional, maintenance-oriented research and towards more anticipatory, ideas-driven approaches. This results from a combination of regulatory requirements, the increasing prominence of hedge funds, the growing sophistication of investors and ever present cost concerns. You cannot speak to anyone in credit research without the cost issue being raised. As Robert McAdie, global head of credit strategy at Barclays Capital, comments: “Credit research is not a service or a library. It is a business.” Banks increasingly need a clear justification for the amounts of money needed to sustain an adequate credit research department. The most obvious way to do this is to stop publishing research and move analysts over to the so-called desk side to work alongside traders. Frequently, but not always, this is allied to banks’ proprietary trading operations. This trend has been apparent for some time, and most firms have decided on one of these two strategies. Unsurprisingly, it is those that have remained focused on publishing research that have proved successful in Euromoney’s credit research poll.
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“We have no plans to move to a desk model. We feel investors are still looking for published analysis” Arndt Muthreich, Dresdner Kleinwort |
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“We have a very different approach to a lot of other houses,” says Benoit Hubaud, global head of credit, fixed income and forex research at Société Générale, which ranked first in both overall investment grade and trade ideas in the poll. “We continue to focus on the client, which is a general priority of the bank.”
This might seem like the kind of puff remark often employed by people trying to make their company look good but in credit research it has substantial resonance. In this arena, client focus is not a universal priority. “The trend of analysts moving to the desk side has resulted in less independence and less availability of research,” says Joseph Biernat, head of research at European Credit Management. “An independent research function is much more useful.” Another house that, like Société Générale, has clearly remained client-focused in its credit research is Barclays Capital. The UK bank was uniquely ranked in the top 10 for each of the 50 categories in the poll. This is impressive given that, in the research industry, individual analysts carry far more weight than the banks they work for. So is Barcap’s success simply attributable to its having first-rate analysts across the board? McAdie argues that there is a more systemic reason. “We try to incorporate a more holistic approach, rather than having individual analysts concentrating on research around relative value or corporate dynamics,” he says. “Credit, quantitative and relative value analysis must be connected to achieve maximum effectiveness.”
So banks have to decide if they want to add value to their research teams by moving them to the desk side, or continue to focus on clients that might reward that service with extra business.
Third option
Or do they? Some research houses are now falling into a third category. That is, those that try to do both things. One house that has tried to do this is BNP Paribas. The French bank ranked first for overall investment grade in last year’s poll, but fell to third this year. This might well be because the bank split its credit research team almost exactly a year ago, with roughly 65% of analysts moving to the desk side, leaving the rest to constitute a slimmed-down, client-focused research team. BNP Paribas plans to bounce back next year, though, and has already added two key people to its team, with plans to further increase the headcount. “This last year has been one of significant transformation in our research capability,” says Marc Watton, head of European credit research at BNP Paribas. “We want to be seen as the most productive of any research house. My personal goal is to be number one again.”
Other banks looking to provide a full-service credit research facility are now adopting this hybrid model. One is JPMorgan, which ranked first in high-yield research and, like Barclays Capital, scored well across all of the poll’s categories. Stephen Dulake, head of the European credit research and strategy at the American bank, explains: “Clients are naturally suspicious of analysts who are in the exclusive pay of traders, but also question the relevance of analysts who are completely divorced from the business. We operate in the middle ground. Our desk analysts complement, rather than compete with or replicate, what we do in credit research.”
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“We want to be seen as the most productive of any research house. My personal goal is to be number one again” Mark Watton, BNP Paribas |
Other houses that are trying to incorporate both client-focused and desk-bound research include Dresdner Kleinwort, which ranked second in overall investment grade, just behind Société Générale. Dresdner recently appointed its first desk-side analyst. But, like JPMorgan, the bank was quick to point out that this was not the beginning of a general shift over to the desk side. “We still publish and focus very much on fundamental research, coupled with relative values,” says Arndt Muthreich, head of credit research at the German bank. “We have no plans to move towards a desk model. From feedback we’ve received we feel that investors are still looking for objective and unbiased published analysis.” The sophisticated investor
But what of the clients themselves? What kind of objective and unbiased analysis does the modern, sophisticated investor look for in credit research? There are a number of answers. Every investor is unique, and consequently every investor has unique requirements of credit research. For instance, there is contention among investors as to the importance of published research pieces. Although some find them unavailing (one research head could not remember the last time he had read a published piece of research), others still find them invaluable. Then there are those in the middle. “The effectiveness of published research varies,” says Martin Hornbuckle, partner and senior investment specialist at Picus Capital. “Some analysts provide good, timely comment, but published research by its very nature is usually late rather than early.”
Obviously, a research house’s policy on published research will be decided by the type of clients it has. For banks that try to accommodate everyone, however, there is now a trend towards less windy and more succinct publications. “The focus of credit research is moving away from maintenance research to shorter, sharper trade-orientated pieces,” says Duncan Warwick-Champion, head of European credit research at UBS. “Most of our research documents are focused pieces of three to four paragraphs.”
A good thing too, as many of the investors who do read published research rarely get past the first page. “It usually only takes half a page to convey an analyst’s thoughts,” says one investor. “I admit to often only reading the front page of research documents.”
Investors who ignore published credit research rely exclusively on establishing a dialogue with the analysts themselves. It is in this area that the qualities of an individual analyst are most important. For investors whose only contact with research houses is through personal contact the relationship with an analyst is everything. Dresdner is one bank that focuses much of its research through established relationships. “We have made a big push to meet, and develop a dialogue with, investors,” says Muthreich. “For a long time we have had a high degree of stability in our research team. Investors have got to know our analysts and appreciate their accessibility.”
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“Clients are suspicious of analysts who are in the exclusive pay of traders but also question the relevance of analysts who are completely divorced from the business” Stephen Dulake, JPMorgan |
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It is pertinent that Muthreich makes special mention of the stability of his team. In an industry that is fast losing analysts, the ability to retain talent can make the difference, as it is undeniably important in maintaining crucial relationships with clients. With many banks downsizing their research operations, and what analysts that are left being offered better money away from fundamental credit research (by, for example, high-volume trading desks at hedge funds), there is no great depth of talent within the market. The single biggest concern in credit research is talent retention. Even Dresdner, with its stability, is not immune. “Some people have recently left and will not be replaced,” says Muthreich. “We aim to maintain the same model, but become more focused.” Defaults rising
The fall in the numbers of capable analysts in credit research might become more of a problem for banks when the credit cycle finally turns. In the benign credit environment of the past couple of years, credit research has understandably taken a back seat in many financial institutions. As one investor remarked: “No one talks about results when they’re all up.” During the last zenith of credit research, in 2002, default rates were as high as 11%. In 2006, that figure was around 1.8%. Now, though, default rates have crept above 3%, and many in the industry are expecting a sharp rise in the importance of credit research. “People are anticipating a rise in default rates, and as a result are reducing investment levels in areas critical to strong performance,” says SG’s Hubaud. “Coupled with rising M&A and, especially, LBO activity, this means that credit research has to be much more careful than in recent years.”
That credit research will become more important as the credit cycle turns appears to be an almost universally held belief. However, many research houses are not prepared for the expected forthcoming downturn. Generally speaking, credit analysts are stretched across too many sectors. They cannot devote the time and effort required to assist a high-volume trading desk. There are still a lot of smart analysts out there but with more and more moving to the desk side and cost concerns over maintaining large, independent research teams, there simply aren’t enough around to maintain the right levels of research in a period of higher demand that the credit downturn will bring.
Nowhere is this more true than in published research. When investors and other clients are only giving research documents cursory glances it is easy to imagine that there is more than enough research out there. But when people suddenly start reading every page of every document because the credit environment demands such vigilance, it might become apparent that the amount of quality research is less than adequate. “There are now questions about published research, says Hornbuckle. “With the stream of people towards the desk side, there are fewer seasoned analysts,” he says. “The level of experience has diminished, and this situation won’t improve. The overall quality of published research will continue to diminish over time.”
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“We continue to focus on the client, which is a general priority of the bank” Benoit Hubaud, Société Générale Benoit Hubaud, Société Générale |
If this does turn out to be the case, those banks that are committed to sustaining high levels of published research will set themselves apart – especially within the domain of structured credit. Recent years have seen not only the introduction of many new structured credit products but also a significant rise in the levels of investor knowledge, not least because most investment firms now have their own in-house analysts. If a research house wishes to remain useful to structured credit investors, it must be committed to continuously growing and improving. The strongest bank in structured credit research this year is JPMorgan, which certainly fits this bill. “Our current commitment to credit research is absolutely sustainable given the growth that we have seen, and expect to continue to see in the underlying business,” says Dulake. “In fact, end-2007 over end-2006, we have planned a modest increase in the number of research heads.” The research houses that continue to put out timely, relevant research will have to do so despite the costs involved. This requires high levels of executive commitment. The banks that have been successful in the poll have done so because their managements have recognized the value of their services, and have provided funding through their revenue-producing departments. Those houses that have not might find themselves being left behind, and some are hurriedly trying to remedy the situation, adding resources to previously downgraded research departments. As Watton at BNP Paribas says: “We see investors of bonds and CDS favouring banks with well-staffed research teams putting out quality research, including trade ideas.”
Short-sighted
If the credit environment deteriorates, the trend of downgrading client-facing research teams might well be exposed as something of an error. And it is a situation that can only get worse. The longer the industry doesn’t have a critical mass of analysts, the more difficult it will become to recruit them. If there is a significant downturn in the credit cycle in the next 12 months (which some would certainly dispute), then those houses that have held on to their research teams, or have already started adding analysts, can expect to figure high up in next year’s poll. Those that have slimmed down their research departments might find they have inadequate resources to cope with renewed demand for fundamental research.
Dresdner’s Muthreich puts it succinctly. “I wonder if some houses [that] have let go of whole research teams aren’t being a little short-sighted.”
