Credit Research 1999: Telling the wheat from the chaff


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As credit research burgeoned last year there probably were analysts who could command seven-figure salaries. Demand is still high but supply is catching up. The best research houses are formalizing their approaches and a pecking order is developing. Rebecca Bream looks at what's on offer.

Credit Research poll results: Moving down the credit curve
Credit Research: Methodology

Have you heard the one about the million-dollar credit analyst? Apocryphal tales linking those in the once lowly field of credit research with heavyweight salaries were flying about the market in 1998. European economic and monetary union is the catalyst for the buying of credit by many investors previously used to interest-rate and foreign-exchange risk. As European investors warm to credit, and particularly venture into the dimly lit nether world of high-yield debt, credit researchers are in demand more than ever to sort the winning deals from those likely to default.

Last year skilled credit analysts were in short supply, their market price was rocketing and poaching was rife. Those with good reputations were in demand and moved rapidly from house to house. Greater rewards brought greater pressures: analysts were expected to cover a wider market and play more of a sales and origination role for banks. Credit research is certainly no longer an obvious option for shy and retiring types who hate to travel.

But it seems the bubble might have burst in 1999. Supply of analysts is starting to balance demand and banks are settling on their credit teams. For analysts exploring the job market, salaries are falling far short of last year's expectations. Investment funds continue to hire credit researchers at a rapid pace, but they can't match the money offered by banks, and are becoming an acceptable "retirement" option for those wanting a quieter life.

Although cults are growing up around individual analysts, will any credit researchers ever reach the superstar status of their equity counterparts? The fact that they work with fewer risks and cover fewer names may always give them lesser importance. Analysts in the field of high-yield debt encounter risks much closer to those of equity and deal with companies less well known to the financial markets. They therefore often command higher salaries.

The market is sifting through the growing pile of credit research produced by the banks and increasingly differentiating between the good and the bad. As the results of the Euromoney poll (page 132) show, teams with experience in credit are trusted to be effective and impartial, while many others are just seen as pushing their banks' deals and not addressing the issues particular to corporate debt.

Analysts are trying to define where they stand compared with their equity market and rating-agency counterparts, as part of the continuing development of European credit markets. With reams of research from all areas of investment banking, it is often asked why we need so many credit researchers anyway.

As analysts will rush to assure you, credit research does occupy an important and growing role in European investors' task of assembling their portfolios. "Investors are looking to take more credit exposure and want to know what they are buying," says Clive Parry, credit strategist at Morgan Stanley Dean Witter.

"Credit research is increasingly valuable as it provides potential investors with a view of the potential risk-reward situation," agrees Geraint Thomas, head of the newly established fixed-income credit research team at Commerzbank.

Credit research is necessary now more than ever for several reasons. "With companies often raising high-yield finance in preference to an equity IPO, credit analysts are often the first to get to know some companies," says Alasdair McPherson, head of high-yield research at Paribas. Likewise, some corporates that issue debt don't have credit ratings. "A huge part of our business is to look at unrated companies," says Joe Biernat, global head of credit research at Paribas. Biernat is leading Paribas' expansion into ratings advice, helping companies with their capital structures and introducing them to ratings agencies.

The characteristics of the various forms of research, though they converge on some fundamentals, are different in key criteria. "There is a different emphasis rather than different techniques," says Thomas. "The way an equity and a bond analyst look at company strategy and the asset side of the balance sheet is virtually the same. But when we look at liabilities, we see differences. What's good for the bondholder can be bad for the shareholder."

For instance, equity analysts are concerned with earnings per share, dividends and shareholder value whereas credit analysts look at cashflow and amount of leverage. A high-profile acquisition may boost a company's share price but the extra debt required to make the purchase will decrease cashflow and damage the credit. "While high-yield credit analysis is similar to equity research there could be developments that favour or disfavour bondholders versus equity holders," says Bala Ramakrishnan, European high-yield telecom analyst at Morgan Stanley. "The high-yield investor focuses on the upside similar to the equity holder but a high-yield investor is much more concerned about asset protection on the downside."

Building on the rating

Rating-agency research is often used as an effective starting point for analysts and investors alike, but is insufficient. "Our credit research is meant to offer a view on a credit that would supplement views of the ratings agencies," says Ed Marrinan, head of European credit research at JP Morgan. "They do good work but their bureaucratic nature slows down their decision-making." Ratings agencies tend to be conservative, rarely awarding investment-grade ratings to young companies. "It is not in the interests of the ratings agencies to go out on a limb," says Simon Adamson, head of financial institutions credit research at Deutsche Bank. "They are concerned primarily about the default rate and the timeliness of repayment so they need to be cautious."

The agencies will look at each company maybe once or twice a year, but a good credit analyst will monitor daily developments. Also, each rating band will include companies with diverse credit fundamentals and whose debt trades at a variety of spreads. For example, at the end of February Geberit, rated B, was trading at a spread of 307 basis points. Central European Media's bond, also rated B, was at 1,167bp. "Ratings agencies have only got so many ratings they can give, and don't update them on a day-to-day basis," says McPherson at Paribas. "News flow is very important, especially in high yield, and it alters price. We react quickly to market-moving news."

More important, ratings reflect a company's credit fundamentals but don't provide a view of its market value. "A rating is not meant to be market-sensitive, it's a blunt instrument even in high-grade corporate debt," says Biernat at Paribas. Says David Meade, senior investment-grade industrial analyst at Morgan Stanley: "Credit research ties fundamental analysis into market trading, combining underlying credit and performance."

Second-guessing the ratings

"One of the roles of the credit analyst is to second-guess the ratings and find market opportunity," says Adamson at Deutsche. An effective credit analyst will spot when a company is underrated and will recommend it to buy-side clients. "Our research is transactional and focused on relative value, opportunities to make more money," says Marrinan. "We want to ensure the investors are being compensated properly for risks being taken."

Using credit ratings as a starting point, credit analysts investigate a company using their own criteria, often conferring with equity-research counterparts if their work overlaps. "We use each other as a resource," says Martin Hornbuckle, European high-yield telecoms analyst at Donaldson Lufkin & Jenrette. "It prevents duplication of work," agrees Ben Booth, the firm's European high-yield credit analyst. There are rivalries between the two departments in a bank, though, and they look for different things in an issuer. "We will hear what our equity counterparts have to say but at the end of the day we have to focus on the fundamentals of our industry," says Biernat.

Credit analysts are producing a growing body of research dealing with new bond issues, bond performance in the secondary markets and studies of different sectors and factors affecting the markets. "Investors are always deluged with more research than they can read," says Hornbuckle. "But they exercise quality control and know which research adds value." Banks are increasingly taking advantage of new media to cut down the weight of paper that reaches investors' desks. Buy and sell recommendations are now regularly disseminated by fax and e-mail. More substantial research with a longer shelf-life tends to be sent out in hard-copy form.

Analysts are now combining sections on credit strategy as well as credit fundamentals in their research as part of the education of investors. This seeks to explain why spreads might change even when an issuer's credit doesn't, and looks at market fundamentals.

"There are two levels that we have to work on," says Biernat. "We have to make sure that what we say is understandable to sophisticated and unsophisticated accounts, and also to develop better analytical tools. The market is still at the early stage of development in research products."

Selling the idea of a deal to potential issuers and investors is becoming a larger part of an analysts' job. This may involve persuading companies to issue and explaining the details of credit analysis to them, and attending roadshows and investor meetings to talk about deals. "Some houses have always involved analysts in the primary side," says Shira O'Reilly, European credit strategist at Deutsche Bank. "Research analysts are a tremendous resource, and the fact that they can be leveraged in all areas of the business is not always fully realized." Adamson at Deutsche also notes that more of his time over the past year has been engaged with analyzing the secondary market, as the trading of credit increases. "But given the strength of Deutsche's origination capability, there is also a large focus on new issues," he says.

Ramakrishnan at Morgan Stanley gives an idea of how much time he spends away from producing research. "Half my time is spent on origination-related activities and half with investors." he says. When dealing with a company new to the debt markets, credit analysts are brought into the origination process early to check out the risks of going ahead with a bond. "Credit researchers generally get brought in at least two months before the deal is launched," says Ramakrishnan.

In some circumstances corporate debt deals need to be done in a matter of days, requiring quick decision-making from credit analysts. When the high-yield market was laid low by the Russian crisis in October last year, telecoms companies NTL and Telewest decided to launch two high-yield deals that helped reopen the market. Both were conceived, analyzed and sold in under a week, and were led by DLJ. "These quick deals can only be done by established issuers analysts that are already familiar with," says Hornbuckle at DLJ.

Credit analysts' judgements are influential in whether a deal goes ahead. When one bank was considering working with a start-up telecoms company on a European high-yield bond deal it called in a credit researcher to analyze the credit. The bank has a relatively conservative approach to risk and the analyst advised against underwriting the deal. The origination team accepted his view. The deal was eventually done in January ­ with some difficulty ­ by another firm.

But conflict does exist between origination teams looking for new deals and analysts with the final say. Some analysts admit they have been placed under pressure by colleagues to give an issuer the all-clear. But most will stress that their banks realize that in the long run it is in a bank's interest for credit analysts to be impartial. "Conflict is an in-built part of the origination and distribution of credit products," says Marrinan at JP Morgan. "There is always conflict over perceptions of credit, this is why we have a market. But we offer objective views to whoever we are working with. If we try to portray a single-A credit like a double-A credit the joke will be on us." Often problems between analysts and origination teams boil down to disagreements over pricing rather than splits on whether to do a deal.

"At Deutsche, if credit research is going to be produced, the analysts get involved early so the origination team knows what the analyst's view is," says Adamson.

Some credit-research teams focus their research more towards the secondary market than others, and only produce primary research to support bond issues led by their banks. "Our credit research opinions are frequently in support of deals that JP Morgan is underwriting," says Marrinan. But analysts maintain that this doesn't necessarily compromise the interests of their clients. "Investors are smart enough to differentiate between the more explanatory research written to support a deal that you are lead-managing and research highlighting value situations in the secondary markets," says Thomas at Commerzbank. "But your integrity is important and it is your role to highlight both strengths and weaknesses" Marrinan can see why investors may be suspicious. "I don't blame investors for being sceptical, but we give them the full view of the credit, good and bad," he says. "There is often wariness over the impartiality of primary research," says O'Reilly at Deutsche. "Secondary research is often more unbiased."

William Healey, director of fixed income at Merrill Lynch Mercury Asset Management, says he trusts the opinions of a few analysts well known for their experience at banks including DLJ, Merrill Lynch, Deutsche Bank and Morgan Stanley. "The others need to be taken with a grain of salt," he says. Healey thinks that these problems exist more in investment-grade research than in high yield. "High-yield issuers are very highly leveraged and disclosure has to be open to avoid legal action. Everyone knows the risks involved."

Stephen Holmes, credit analyst and fund manager at Fleming Asset Management, commends the research products from Warburg Dillon Read, Salomon Smith Barney, Dresdner Kleinwort Benson and DLJ. "We do our own research," he says. "But the investment bank products are invaluable for factual background and for keeping up to date with developments. In terms of the opinions, they vary in their objectivity."

Sensitive issuers

Analysts are working out how to let investors know their views on specific bonds in ways that will not aggravate sensitivities with fellow bankers. Researchers must also be wary of upsetting issuers, who sometimes insist on seeing what a bank's analysts have written about them. Analysts are frequently asked to change their reports' wording.

Issuers' attitudes towards analysts vary between welcoming and helpful to evasive and even obstructive, often depending on how sophisticated their local credit market is.

The level of understanding of credit and standard of disclosure varies by country and by sector, and is higher in telecoms and media than in traditional industrial sectors. It also depends on whether a company already has a listing or is private and unfamiliar with capital markets. "Quoted companies understand perfectly well disclosure levels and the need to educate and inform potential about the company," says Thomas at Commerzbank. "Some private companies perhaps misjudge the extent of ongoing information they need to provide to make their deals a success."

"Some companies have never had to deal with analysts before," says Booth at DLJ. "But it is bankers who have the role of educating the management. There will be pressure on the house bringing a deal to make sure the company discloses information in an appropriate manner." Issuers of credit in Europe must also improve the treatment of their investors. With everybody focusing on improving shareholder value, few companies give a high priority to the needs of their bondholders. "Start-up firms and leveraged buy-outs often don't have listed shares," points out Holmes at Fleming Asset Management. "The equity investors can take a longer-term view so their interests are aligned with the company and they want to keep bondholders happy. The battle between shareholders and bondholders is more fierce in investment grade."

Investor education also varies across Europe. "There are deep pockets of sophistication in the UK and Benelux where private-sector pension funds have been in place for some time," says Marrinan at JP Morgan. "Their credit skills easily rival those of the US market." In other countries, credit skills may be underdeveloped but investors are learning quickly. "The demands of investors in European high-yield research continue to change," says McPherson at Paribas. "The job of an analyst is to pitch research at the level that educates investors and adds real value."

Most funds are starting to assemble their own teams of analysts. "All the high-yield funds have credit analysts, and in investment grade the figure is about half," says Parry at Morgan Stanley. "I have regular contacts with 30 to 35 analyst counterparts at investment funds," says Ramakrishnan at Morgan Stanley.

The analysts interviewed here come from diverse backgrounds including two ex-rating agency analysts, two from sales, one former bond trader, one chartered accountant, one ex-loans analyst, and one former asset manager. Only one analyst was trained in credit straight from business school.

Learning from failures

Most banks have plans to set up graduate training schemes to increase the pool of credit analysts in Europe, but stress that it is important for analysts to have wider experience of market highs and lows. "The ideal background for a credit analyst is to see a situation go wrong and than be responsible for sorting it out," says Thomas at Commerzbank. "You then understand exactly why companies fail, and you can see the difference between a good and a bad company time and time again."

"There was a limited universe of trained staff in Europe and this created a lot of excitement in the sector," says Marrinan. "But supply and demand will balance over time as more Europeans develop such skills." Thomas points out that bank mergers are leading to banks cutting overlaps and creating a pool of analysts looking for jobs.

The frantic pace of job-swapping that occurred last year has slowed down. In the case of one high-profile departure this year, that of credit stalwart Rick Deutsch from Merrill Lynch, we are still waiting to hear where he has landed.

A senior credit analyst with experience of the US market and dealing with higher-yielding bonds may continue to command a six-figure salary. And up-and-coming researchers who get on well with issuers and investors and are known to add value will still be poached. "I get lots of phone-calls from head-hunters," says one analyst. But another characterizes the pay as "patchy" and notes that "with lots of credit analysts on the market I'm not sure how many senior jobs there are to go around".