Credit research poll 2002: Credit analysts get back to fundamentals


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Interviews with the front-runners in this year's Euromoney credit poll indicate a market in flux and efforts on the part of credit research teams to adapt to this. At a time when equity activity is subdued, the credit market stands out as lively but also highly volatile throughout the rating spectrum. This means that the top firms are doing their best to find new ways of presenting research to their varied customer base. Timeliness, focus and independence in their reports are crucial but they must produce this with staffing levels that are generally substantially lower than those of their equity colleagues.

Credit research poll 2002
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Methodology and voter profiles

This should be the moment when banks' credit analysts, long the poor relations of their more celebrated colleagues on the equity trading floor, finally come into their own.

First, theirs is the market with all the momentum. The credit market in Europe has doubled in size since 1999. The asset class continues to grow - the 940 replies to Euromoney's credit poll this year, compared with 340 last, is testimony to this. In Europe in particular, new funds continue to be dedicated to credit investing at a time of shrinking primary market supply. That provides strong technical support, despite all the recent credit blow-ups, such as at Marconi and Swissair, and all the concerns that have swirled around Invensys, France Telecom, Sonera and others.

In 2001, a year when Argentina defaulted, Enron went bankrupt and downgrades outstripped upgrades by a record margin, credit still outperformed the equity markets. Who is to say it won't again this year and outstrip government bonds as well?

Second, the concern about accounting practices and disclosure that has gripped securities markets in the wake of Enron's collapse should play to credit analysts' strengths. Equity analysts have been more concerned with profit-and-loss statements and with forward-looking calculations based on these. But the P&L statement is the form of financial reporting most prone to abuse by companies keen to put a flattering slant on their results.

Credit analysts - good ones at least - concentrate far more on balance sheets and cashflow statements, the last of which at least should be less open to weird and wonderful pro-forma inclusions and exclusions. They should also be more used to ferreting around in the notes to published accounts, in search of all manner of third-party guarantees, put options and contingent liabilities, which can substantially increase reported debt levels. 

"It's the first thing we ask potential new recruits," says Gary Jenkins, head of credit research at Barclays Capital. "How do you read a company's accounts?" If you ever go for a job interview at Barclays Capital, the answer he's looking for is back to front - starting with the notes. Emmanuel Weyd, head of credit research at JPMorgan, agrees. "The P&L, the balance sheet, the cashflow statement - these things cannot tell you everything," he says. "You have to go through dozens of pages of notes - it's painful, fastidious, even boring because they may disclose nothing. They may, however, reveal the existence of various commitments, options and off-balance-sheet liabilities, but in an incomplete manner. Then you have questions to ask the company."

Third, it is now clear that credit events have a strong impact on the equity markets. Falling share prices at the major telecom companies - France Telecom shares fell from e195 in April 2000 to e33 two years later - are inextricably linked to falling credit ratings and the need to deleverage. Credit analysts now say with some pride that equity research colleagues are, for the first time, coming to seek their advice on how credit concerns might affect the outlook for share prices.

Fourth, credit markets have become almost as volatile as equity markets, putting a premium on the best analysis and recommendations. Wide swings in prices provide opportunities for the brave - and, it's to be hoped, the well informed - to take profitable positions. They also create traps for the unwary and unlucky, especially for those required regularly to mark positions to market. "The days of buying a credit, putting it away and forgetting about it are long gone," says Marc Pinto, head of credit research at Merrill Lynch. "You have at the very least to monitor each holding. Some investors now are showing us their portfolios and asking: 'What should I be worrying about?'"

A lot, reckons Thomas Crawley. "Outperformance means avoiding the land-mines and this requires analysis and not having portfolio managers take decisions on the fly." The head of European corporate bond research at Schroder Salomon Smith Barney continues: "In the US some of the top investors have larger in-house research teams than the Street, but not in Europe. Only the top 10 accounts have decent size in-house analysis." 

What's more, Enron raises the spectre of the unknown. And though it seems unlikely that any European companies have embraced the hugely complex financing structures and the asset-lite strategy of Enron, ownership structures in Europe can be complex and disclosure poor. Crawley says: "European investors are much more exposed than US investors. Disclosure in Europe is well behind the US. And there are some companies that will succeed only if each part of their operations is functioning well. Take out one card and the whole house comes falling down." It's the job of bottom-up analysts to warn investors of the dangers.

Meanwhile the growth of the credit derivatives market has made it possible for some investors - notably hedge funds and convertible arbitrage funds - to take outright short positions against credits they think will underperform. If analysts are bearish on a credit, some accounts can take advantage of that.

Investing solely or mainly on the basis of rating-agency bands has become an almost useless strategy. The best-performing and worst-performing European bonds in 2002 up to early March have almost all been BBB rated. Spreads on the KPN bond due October 2005 had tightened by 88 basis points from the end of 2001 to March 7 2002, while spreads on the Invensys bond due April 2005 had widened by 319bp. Sonera and DaimlerChrysler bonds have tightened by 50bp in the same period, while spreads on Fiat and France Telecom bonds had widened by 87bp and 60bp respectively. All these credits are BBB.

The simple barbell credit investment strategy of overweighting AAAs and BBBs that was popular late in 2000 is a distant memory. Specific events can drive extreme movements in the prices of any bond. The worst performer in the year to March 7 is A-rated ABB's bond due March 2004, which widened by 319bp. Rating agencies perform a valuable function - they may, for example, force companies to deliver on promised asset sales and equity issuance under the threat of downgrade if they fail. But the wide dispersion of spreads and performance of similarly rated credits means their usefulness is limited.

It's vital for investors to have a firm view on individual names rather than on sectors or rating bands and this, in theory, should send many of them scurrying to the credit analysts for insight into the fundamental strengths and weaknesses of individual credits and for smart calls as to relative value in these fast-moving markets.

But credit analysts aren't rejoicing in their new-found celebrity. Rather they are worried by several thorny challenges.

First of all they are extremely stretched. For example, Said Saffari, head of credit research at CSFB, has 15 credit analysts reporting to him. The firm employs 300 equity analysts. That's typical for the top dozen or so firms. The average credit analyst might have to cover 30 or even 40 issuers; the typical equity analyst might cover a dozen companies. "The equity teams have unbelievable resources in terms of databases and other information which we try to use," says Saffari. "I spend a lot of time talking to the equity analysts here. When a company is in a crisis in which debt is a key driver they're very keen to integrate our perspectives."

Like credit analysts at many firms in the past year Saffari has even found himself presenting to equity investors in roadshows. 

Debt analysts may find it advantageous to listen to company managements addressing equity investors. The down side is that it's yet another call on the time of people who are already much in demand.

At many firms the credit research teams are headed by analysts who still spend most of their time covering key sectors and have little left over for managing, such as Crawley at Schroder Salomon Smith Barney, who follows telecoms. The head of credit research at another firm says: "When you had enormous concerns around Deutsche Telekom, France Telecom, KPN and Sonera, just covering those four companies was a full-time job."

Anja King, co-heads the credit research group at Deutsche Bank and also covers telecoms. She says: "I have many more counterparts on the equity side. Sure we feel stretched. It can take anywhere from two to five days to put out an in-depth piece on a company and by the time it's out people won't read it in today's environment because the market has moved dramatically."

In a market prone to extreme reaction to news announcements about deteriorating financial performance or sudden fits of anxiety about hidden liabilities, analysts are often reacting to the news, trying to offer a quick interpretation of its likely impact and focusing on sentiment and market technicals rather than credit fundamentals.

It doesn't help that the consumers of their research, both in-house and outside, are a hugely diverse group with contrasting interests and concerns. The in-house proprietary trader or the total-return hedge fund customer might demand near instantaneous comment on the minutest detail of news about an issuer. The portfolio manager at the buy-and-hold insurance company will have no interest in this but might be more interested in a considered longer-term view on portfolio reallocation.

Investors' basic understanding of credit is also varied. "Continental European investors have developed their credit expertise tremendously in two years but there can still be large differences among the investors I meet at regular briefings that we host," says Rick Deutsch, European head of high-grade credit research at BNP Paribas. "There are a lot of very smart guys on the buy side, who come out with questions that really stretch you. But there are also some who are less sophisticated."

Meanwhile the in-house debt capital markets team will be asking for new-issue research that few end investors will actually read and which, more often than not, is designed to flatter the issuing company. New-issue research notes raise questions about the independence of published reports. Those written by a lead manager in advance of a new issue are almost always shown to issuers to check that figures are accurate, and issuers and investment bankers will often offer credit analysts a helpful opinion or two over the wording of some of their views.

It's a bit of a game. Many analysts will quietly encourage investors to read research from other firms not underwriting a new issue. "Let's not be naive, you're never going to blast a company that you're leading a deal for," says one head of credit research, "but then investors know that."

An even greater concern among analysts themselves is that writing long new-issue pieces is a huge distraction. "I think Salomon has some fantastic analysts," says the head of credit research at a competitor, "but I wonder if they haven't shown up so well in your poll because they're spending so much time on new-issue research given the firm's position in the primary market."

Addressing all these different audiences is tricky. "The key credit investors in the US all tend to have a relatively similar focus. But our audience in Europe is much more diverse," says John Raymond, managing director, European corporate bond research at Lehman Brothers. "Written research is a key way of communicating, but you can't write separate reports for different sections of the audience. Equally important is the additional relative value advice you give one-to-one, and that will depend on whether you're talking to total-return accounts or, say, banks, which still form a large part of the investor base in Europe. They are looking for different inputs." 

The firms that have done well in this year's credit poll certainly have good analysts but they have also paid a lot of attention to how best to deliver their research and views to a heterogeneous investor base. Catherine Gronquist, director of international credit research at Morgan Stanley, is that rarity among credit research heads, a manager with no direct responsibility for covering a sector herself. Gronquist has been at Morgan Stanley for 21 years, managing credit research for the past two, having been in sales before that. She says: "In terms of how we're organized we've spent a lot of time focusing on what clients really want and we think that is research that's readable, clear, consistent and executable. It's no good just making an early, counter-consensus call, as for example [Morgan Stanley credit strategist] Neil McLeish was spot on with on going overweight cyclicals, unless you can show the customer what trades he can put on to act on that call." She adds: "Having a full-time manager helps us establish the framework for all of that that."

Morgan Stanley's competitors suspect that its credit analysts spend more time talking to investors and less writing long research reports and Gronquist partly bears this out. "We see ourselves as part of the credit products group in which all the moving parts have to work together, including research, sales and trading. To some extent the we are an extension of the sales force since we also have a lot of direct contact with clients. A lot of customers say to us: 'I like your model portfolio, can you show us how you constructed it and how we might use it.' We're more into the customer problem-solving approach than just felling trees and writing research reports in isolation."

Thinking like an investor

The model portfolio approach is one that distinguishes Morgan Stanley. Using a proprietary model portfolio is an additional step beyond simply recommending to investors that they go overweight or underweight certain credits or sectors against one of the credit market benchmarks.

Neil McLeish, one of the veterans of the credit research team at Morgan Stanley and now its strategist, says: "There is a cost involved in changing your investment view. You can recommend trades every day but no investor is going to execute all of them. We rebalance our model portfolios in a very disciplined way once a month and try to think about the world in the same way as a portfolio manager." Another virtue of the approach is that it forces other sector analysts on the Morgan Stanley team to think not just of relative value between the names they cover in their own sectors but in terms of relative value between sectors. Changes to the model portfolio are keenly debated internally.

The firm also takes care how it communicates its views. "We'll produce a written report and also call accounts to explain our reasoning," says McLeish. "If you don't make the follow-up calls the impact of what you publish is much reduced. It's a mistake to think that just because you've published a report and distributed it, investors will pay any attention."

Goldman Sachs has also fared well in this year's poll and its heads of credit research also stress the importance of direct contact between analysts and investors. "We've spent a lot of time strengthening the critical relationship triangle between the account base, sales and research," says Donna Halverstadt, director of European investment grade credit research at Goldman Sachs. "We've made sure that all the research analysts know all the sales people focused on corporate credit and we've been visiting accounts that we may previously not have spent a lot of time with, establishing stronger and more direct links between research and the customers. We've also been working on further developing the amount of dialogue between research and sales."

It sounds simple enough and quite unremarkable until you listen to the complaints of analysts at some other firms. The head of credit research at one prominent European bank says: "The truth is we don't really have a dedicated credit sales force." Communication with credit investors sounds poor as a result. "We put reminders on all our reports to vote in the Euromoney poll but when we checked with salesmen covering the accounts and asked them to remind investors to vote it turned out that investors were saying they hadn't even noticed."

At Goldman Sachs, Halverstadt and her colleague on the high-yield side, John Fusek, have been spending a lot of time thinking about what types of reports customers want and in what manner they want them delivered. "It sounds obvious but they must be timely and they absolutely must be value added," says Fusek. "They must be clear, and they must have insightful commentary." Rather than reacting to news, Fusek sees value in anticipating results announcements. "Many investors find value in reports issued before a company's announcement saying 'these are the key figures to watch, these are the acceptable ranges, if the numbers are worse than that, watch out.'"

Goldman realizes that while its written research has to appeal to a broad audience, "investors can always get more by talking to the analysts," says Halverstadt. Fusek adds that in volatile markets Goldman analysts have learnt not to be neutral on the bonds they cover but rather to increase the number of companies on which they put an outperform or underperform recommendation. "Obviously investors want stability but in a volatile market if you have convictions you have to call bonds cheap or expensive. If a bond has gone from par to 90 to 80 and you're still negative, you've got to say, even at 80, 'sell it now.'"

Another key challenge for credit analysts is intelligently to marry their fundamental views on specific credits to their sense of market sentiment and technical factors. Often the two can drive prices in different directions. Technical factors, such as tightening swap spreads and poor performance of other asset classes in 2001 and growing demand and shrinking supply in 2002, overcame negative fundamentals. Credit broadly performed well.

In February 2002, the constant flow of bad news from companies, including slow progress with balance-sheet repair for key issuers in the credit market, such as Deutsche Telekom, and worries about contingent liabilities, overwhelmed the positive technicals, notably signs of a recovery taking hold in the US economy. Spreads blew out and market sentiment turned sour.

Now the balance between technicals and fundamentals, long tilted towards technicals, is uncertain. Traders always itch to put on positions when bonds hit record wide spreads: but are they really cheap or are there more horrors to come?

Weyd at JPMorgan is worried. "My biggest concern is that we get a lot of good news on the economy and that spurs a phenomenal rally and investors don't perform due diligence. I believe the market has lost some investment discipline, shooting first and asking questions later in bad times and buying everything in bullish times." Meanwhile extreme volatility now appears to be a permanent feature of the market. Partly this may be because of its illiquidity.

At Euromoney's bond congress in February a lone investor spoke for many of his peers when he questioned a group of bank traders recommending use of the credit derivatives market. Before rushing ahead to the derivatives market, wouldn't it be better to fix the cash market, he asked. "You have a lot of people called traders at banks who appear to being paid not to trade. If you're negative on a credit, the banks will say 'what a good analyst you are, we're negative too. Certainly we won't bid it off you.' If you want to buy bonds they'll never offer you any they don't already own, for fear of not being able to source them."

It sounds like a stinging criticism, though maybe a touch naive. Illiquidity has drained from the bond markets since the Russian and LTCM crises of 1998. And given the large size of the biggest fund managers relative to banks' balance sheets, firms aren't going to bail investors out by buying large volumes of bonds in distressed markets.

Meanwhile, bond prices whip around on very low volume. One head of credit analysis says: "This February we saw big headline spread movements of 100bp - that can be 10 percentage points in price. But, particularly down the credit curve, while there was a fair amount of shorting by the street and by hedge funds and then short covering, there was very little customer flow either as spreads blew out, or as they tightened in again."

His view is that for the rally that began in late February to continue, end investors will have to start buying. There may be some signs of this. A number of French institutional investors that were thought to be full up on France Telecom sought new capacity for the credit when its spreads blew out in February, and their buying contributed to its rally.

Technicals good, fundamentals bad
Now analysts will be spending much time assessing the potential impact on corporate performance of the initial stages of economic recovery. Again technicals and fundamentals can pull in opposite directions. Weyd explains why his team put out a strong buy recommendation on Ford when its spreads blew out to 300bp over and continues to recommend the auto sector including selected weaker names. "We may be overweight autos for what look like the wrong reasons. We think the credits will deteriorate, sales will be down while profits and cashflow should remain ugly. But valuations are attractive, we think the flow of bad news will be less than before, supply will be less than it was and that a lot of positive news on the macroeconomy will make investors hungry for auto bonds if they want to jump into cyclical assets." Though investors in equities can choose from a wide range of cyclical investments when the economy turns - chemicals, pulp and paper, engineering - these choices don't exist in the credit markets where issuance from these sectors has been far less than from auto companies.

Some credit analysts, in their eagerness to be market savvy, may have developed too much of a trading-desk mentality and developed a better sense of the technicals and forgotten their first duty to comb through the fundamentals of specific credits.

Most heads of credit research pay lip service to the notion that 2001 and 2002 are the years when in-depth analysis of specific credits, and the ability to spot which names to avoid, has become a crucial skill. But how many can really claim to have spotted the blow-ups ahead of the competition?

"To an extent your hands are tied. You only have what managements tell you to go on," says King at Deutsche. She argues that companies have grown used to the idea that it is the job of analysts, especially those at leading underwriters, to market their bonds. King says: "In reality, this is the year when company managements have to build their own credibility - we can't do this for them. Part of that is more than just disclosure - the notion that the key numbers are out there somewhere for analysts and investors to find in some filing such as a 20F if they have the time to comb through them - it's about making the numbers available in an accessible, user-friendly and predictable way."

If the price of inadequate disclosure is exclusion from the capital markets, companies will learn that lesson quickly. If the concerns raised by Enron fade quickly, analysts will still have a big job to do warning investors of which credits to avoid and it's one they may not be doing terribly well.

Jenkins at Barclays Capital says: "What I'd really like my guys to do more is pick up a credit on which there's been no news or price action for a while and really go into it in depth, to check it out for all the concerns over covenants and ratings triggers, third-party guarantees, vendor finance, unfunded pension liabilities and so on. But that single piece of work might take three or four days and might produce a neutral report. We haven't got time to do that in today's market," he reflects, "but maybe that's exactly what we should be doing."