Credit research poll 2006: Analysts see the upside of a downturn


Florian Neuhof
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Banks’ credit research departments are readying themselves for a turn in the credit cycle towards a higher level of defaults and volatility. Florian Neuhof reports on the state of play.

Credit research poll 2006
Investment grade overallInvestment grade sector breakdown
High yield overallHigh yield sector breakdown
Other products and marketsMethodology

AT A TIME when default rates are low and spreads are tight, credit research is not enjoying quite the prominence it reached during the days of high volatility and default risk. Furthermore, regulatory changes have prompted many banks to cut back or even scrap the published research they provide. But an increase in event risk, the arrival of new products, the search for higher yields and the expectation of higher default rates mean that credit research is far from passé. Banks have recognized this and are refocusing their research to accommodate the changes in the market.

Credit research’s heyday was the period of extreme volatility during the last cycle of credit decline that started in 2000, when it was also thriving on the back of the nascent European credit market that emerged with the introduction of the euro. Gary Jenkins, managing director of credit strategy at Deutsche Bank, which ranks second overall in high yield and sixth overall in investment grade research, says: “The importance of research has changed; this is a process with ebbs and flows. In 1995 it was not the centre of the market, while in 2000 it probably was. Now it has fallen away a bit again.” The determining factor is the default rate and tight spreads. “In 2002, when the default rate was at 11%, there was a real need for research. At the moment, the default rate is at around 1.8%, so there is not so much need,” Jenkins says.

Mark Howard, managing director and co-head of global research at Barclays Capital, says that apart from the benign credit environment “the dramatic growth of derivatives products has been a factor working against volatility in the market, as these have reduced idiosyncratic risk, which is the backbone of credit risk.”

With default rates low the cycle is likely to turn soon. But as the global economy is stable, volatility is confined to event risk, largely springing from the high level of leveraged buyout and M&A activity. “Volatility overall in the market has not increased, but idiosyncratic risk has gone up significantly,” says Jacques d’Estais, global head of the Corporate & Investment Bank at BNP Paribas. Arndt Muthreich, director and head of credit research at Dresdner Kleinwort Wasserstein, whose team are ranked second overall in investment grade, and 10th in high yield, concurs, stating that event risk has gone up and individual stories dominate the market.

Guido Barthels, DrKWGuido Barthels, DrKW: a lot of information is chasing smaller margins
This is the result of capital markets being full of liquidity, and companies as well as private equity taking advantage of this by undertaking increased M&A and LBO activity. Shareholder pressure is behind the releveraging of companies. “The good days for bondholders are coming to an end,” says Tim Barker, head of credit research at Morley Fund Management.

Rick Deutsch, head of European credit research at BNP Paribas, winner of the investment grade category, says that shareholder pressure means that the onus in the credit market is now to stay away from blow-ups. “Research is the flavour of the month again, ” he asserts. With volatility derived from the change in ratings or defaults of individual companies, the demand for company-specific research has picked up again. “Single-name analysis was temporarily less important,” says Howard. “But this is changing as since the end of 2005 there has been an increase in idiosyncratic risk as M&A and LBO activity is back in vogue.”

Investors have become aware of the LBO threat, too, and are keen to avoid the risk of downgrades to their investments. “The emergence of the leveraged bid has profoundly changed the way that the buy side thinks about the credit they are involved in, ” says William Healey, CEO of Picus Capital.

Credit research is likely to become increasingly relevant to investors when liquidity starts drying up. “At the moment, there is a tremendous amount of liquidity in the market and people are taking risks. Once that changes, people will become more risk averse and the need for fundamental credit research will become more pronounced,” says Robert McAdie, managing director and head of global credit strategy research at Barclays Capital.

Tight spreads and low levels of overall volatility are not optimal conditions for investors seeking to make money from bonds. Credit research is a vital ingredient for making a profit. Good analysis of individual companies is quintessential. “Research is company-specific, and if you predict it right you can outperform in a good and in a bad market,” says Richard Phelan, managing director for European leveraged finance at Credit Suisse, who came first in the high yield category with co-head Ben Booth. BNP Paribas’ Deutsch adds: “Some 18 or 20 months ago it was enough just to buy the telecoms sector; now you cannot just buy the sector – it is vital to know which names to buy... or to short.”

Research has adapted to the demands generated by the market. What investors need these days, says Deutsche’s Jenkins, is not “educational research”. Rather, “credit research is now an opinion tool in the search for value”. Investors value the opinion of the sell side but Jenkins does not believe that there is at present any need for the kind of analysis of sectors or companies that used to figure heavily in research. BNP Paribas’ d’Estais adds: “Research has become more value orientated and less fundamental. There is greater focus on generating profitable trades.” Laura Winchester, managing director and co-head of European credit research at Barclays Capital, third in the investment grade category, also emphasizes the move away from what she refers to as “maintenance” research, and a shift to “anticipatory” research in the search for trading opportunities. With widening spreads expected, a focus on analysing whether individual companies are trading at fair price levels can reap rewards, with stockpicking to become increasingly important in the future.

The growing importance and growing diversity of credit derivatives has also been noted among bank analysts. For example, Benoit Hubaud, head of credit, forex and interest rates at Société Générale, who with his team came fifth overall for investment grade and 10th for high yield, says: “There is a relative value focus on derivatives at Société Générale. Two years ago, credit default swaps accounted for 20% to 30% of our flows, now it’s about 60% to 80%.” Barcap’s McAdie notes that his firm’s strategic advice in 2006 and 2007 will be dominated by the growth of portfolio products. “We will focus on looking at derivative products as products that can be of use to investors.”

Robert McAdie, Barclays Capital: less liquidity will mean more need for researchRobert McAdie, Barclays Capital
The search for enhanced returns has led investors to look increasingly at high yield. And according to Barcap’s Howard: “The high-yield market is likely to gain in significance for credit research. The loan market has become critically important to it and with it the ability to analyse across markets. The growth of structured credits in high yield, more origination and new derivative products, make high yield a fertile ground for strategic and fundamental research.”

The decline of published research seems not to have reduced the amount of research that investors perceive themselves receiving – many claim that they are still inundated by it. “We are seeing a huge amount of information chasing smaller margins in the market,” says Guido Barthels, head of debt research at DrKW. And while good trading ideas and the legwork of statistical analysis from the sell side are still appreciated, the buy side has built up extensive credit research capacities of its own. “We are bombarded with sell-side research, and look at most of it. While we have our own research, we value different opinions,” says Joe Biernat, head of research at European Credit Management. Karl Bergqwist, head of institutional credit at asset managers Gartmore, points out that while investors have become much more sophisticated and demanding, “the sell side remains an easy source of information; they shift through an awful lot of statistics”.

The decision of some banks to replace published research with desk analysts is widely decried by those banks that still publish large amounts of research. Research is widely seen as an important factor in the relationship with the buy side, and some believe that without published research, this relationship will be difficult to uphold. Phelan at Credit Suisse believes that “banks that de-emphasize published research will find it difficult to interact with the buy side at the same level.” Although a research-savvy buy side is inclined to view published research with scepticism – it is likened by Bergqwist to “the brochure for a new car” – there is some agreement from investors that houses with a traditional research approach are relatively highly regarded by investors. “The rewards are intangible,” says Biernat. “They provide a better, more consistent service, which is more likely to be rewarded by a better relationship.”

But, above all, the level of sophistication that investors are displaying has raised the bar for sell-side research. As the buy side is increasingly investing across the capital structure, in derivatives and loans as well as in bonds, the challenge for banks is to provide integrated analysis of the market. The emphasis is thus not so much on the format or the amount of research but on whether it reflects the complexity of the marketplace.

Credit ratings: Emerging in the emerging markets