Fixed Income research poll 2008: A time to shine for credit research
The crunch has precipitated a world where good credits can turn bad overnight. Research teams must adapt to the new circumstances while clients increasingly have their own expertise. Jethro Wookey reports.
|Fixed income research poll results
THIS IS THE sort of environment that credit analysts should thrive in. Volatility, wide spreads and the potential for differentiation among names has elevated the role of a research analyst as clients look for direction in a market where good credits can turn bad overnight. Although 12 months ago many in the research industry were predicting a rise in the importance of credit research as the cycle turned, the nature of that downturn has surprised many. As the liquidity crisis has propagated some peculiar dynamics, such as unsecured debt outperforming secured debt, the process of picking winners has become extremely difficult. More than at any time in the past few years, research analysts are under the spotlight. As one research head puts it: "If you’re not enjoying this period in time, then you’re in the wrong job."
With many primary markets quiet, and most investors not inclined to touch structured finance products, a credit analyst’s job is markedly different from a year ago. Given the sheer moves in the market there are a lot of depressed situations, and bonds have traded aggressively downward. But this is not yet a traditional downturn. Default rates have remained low; the problem is still primarily liquidity. But there are signs that the financial turmoil is seeping into the wider economy. The extent of a US recession and its effects on other regions could be very influential. The level of uncertainty continues to cripple the credit markets. Most people in the market today, including research heads, have no idea what’s going to happen. There is simply no precedent. In such a climate, the demands placed on credit research have grown substantially. "Each time I organize a meeting with clients, I’m very surprised by the turnout," says Benoit Hubaud, global head of credit, fixed income and forex research at Société Générale. "If I expect 25, I get 50. And after each event, conference call or published report, we get feedback from people we didn’t expect."
However, many houses have downgraded their research capabilities recently, as cost-cutting measures force culls across a bank’s employee base. (Even before the credit crunch, many banks were doing this, as the value of a comprehensive research department is hard to quantify.) This is especially true for US banks. Not only have they generally felt the effects of the credit crunch more keenly than their European counterparts, and are consequently under more cost pressure, but US banks have tended to focus their research efforts more on the desk side than most European banks, with many analysts working alongside their proprietary trading colleagues. This form of credit research is geared towards servicing big, fast-moving accounts such as hedge funds, whose investment activity has slowed substantially since the crunch. Consequently, many US houses that service these clients have lost analysts in recent months. But this downgrading is by no means confined to the US. The majority of European banks have experienced fall-offs in their research headcount over the past 12 months.
Whether these movements have been as a result of bank cost-cutting measures or analysts’ decisions to leave, keeping the nucleus of a high-quality team together has always been and is especially now a key concern for any research head. Although there is not a lot of hiring happening on the sell side, the buy side, particularly hedge funds, is still looking to pick up talent from investment banks. A lack of deal flow should not be confused with general inactivity, and that these funds are bolstering their in-house research capabilities is a positive sign.
"After what happened in 2007, it is important to understand the linkages between markets"
Many of the departing sell-side analysts are now looking to their former clients on the buy side, a trend that began well before the credit crunch hit, and one that came about because the economic and regulatory environment encouraged it. But the trend has now become even more apparent, as buy-side institutions have learnt to rue not doing enough of their own research, particularly in structured finance. The crunch and its consequences have forced these firms to address this deficiency, and as a result many on the buy side are looking to pick up seasoned analysts. And there is a substantial supply. Since the credit crunch, it is not just the chaff that is being discarded. Good analysts are finding themselves out of work, and are looking to their old clients for their next opportunity. "We interview a lot of sell-side analysts with more than a little interest in coming to the buy side," says Robin Cresswell, managing principal at Payden and Rygel, a privately owned global investment manager. "Although remuneration is better on the sell side, the equation that analysts are doing in their heads is that it is associated with much higher job risk."
As a result, more and more such firms are now doing the majority of their research in house. According to one investor, who claims that 95% of the research he uses is produced internally, one of the main reasons for this is the perception that research is becoming increasingly less of a priority of sell-side institutions. "The reason we do our own is because we don’t want to worry about analysts getting fired elsewhere," he says.
The amount of time that many buy-side firms spend reading external research is accordingly limited, and so the demands placed on such research to be clear, relevant and efficient are greater than ever. In such cases, having well-known and respected individual analysts can make all the difference, making it even more important to keep such names on board. "The daily process of our analysts includes seeing a four-inch thick pile of research, going through the front pages and picking out analyst names they respect and that have had good insight in the past," says Andy Howse, fixed-income investment director at Fidelity International. "Out of a dozen pieces, you can maybe get one or two good ones."
One bank that has managed to buck the trend and increase the number of its research analysts is RBS, which was the clear winner in the 2008 Euromoney credit research poll. RBS operates a research department that fits well in this time of uncertainty, being big on fundamental analysis and having joined-up coverage across many areas including credit, foreign exchange and economics. And having one of the clearest views and loudest convictions of how bad things would get has played very well with its clients. "The market environment suits our blend of fundamental, bottom-up credit research and strong, opinionated credit strategy," says Kit Juckes, head of fixed-income research at the Scottish bank. "We think we have a tight-knit research team across all areas, and this has allowed us to be very aggressive in interpreting what’s happening in the financial sector."
Juckes’s strategy, legitimized by the poll’s results, is one of utilizing all knowledge and analytical ability across all sectors. If nothing else, the events of 2007 showed how closely markets are interrelated, and a research house ignores one to focus on another at its peril. The global leverage bubble burst first in the relatively small US sub-prime mortgage sector but there’s no telling where it will hit next, be it leveraged loans, commodities or something else. Unless you understand all these market components, you need to be very lucky. "You simply cannot afford to have no opinion on, say, the global commodity bubble," says Juckes. "You need research when the world is a volatile place. You need joined-up research; it’s astonishing how interconnected markets are."
Juckes explains that the barriers between sectors in research are coming down. With so much of the world’s GDP now in emerging markets, the line between credit research and emerging market research is becoming increasingly fuzzy. Where equity stops and debt begins in a firm’s capital structure is now much less clear, and this creates a range of challenges for both equity and debt research. Juckes’s team is not the only one to have seen which way the wind is blowing. "After what happened in 2007, it is important to understand the linkages between markets," says Stephen Dulake, head of European credit research and strategy at JPMorgan. "In order to get a full picture, for instance, you have to understand what the CLO market slowdown means for other sectors. We’ve been getting a lot of calls from our equity and emerging market peers about what’s going on."
"We are always looking for new ideas and new approaches"
This is the new order of things for credit research houses. And until the market environment returns to some form of familiarity, whereby the inconceivable is not a seemingly daily occurrence, research houses have to keep moving or risk being left behind. The demand for in-depth and accurate research will continue to increase, and so research departments must keep moving forward. The Euromoney credit research poll gives us some insight into which banks are managing this successfully. Société Générale, which has made a number of refinements to its research model in recent months, ranks second overall in the poll behind RBS. Among the refinements is the publishing of a new equity research model, reflecting the close association between equity and credit in the present climate. "We are always looking for new ideas and new approaches," says Hubaud.
There are now signs that the wider economy is entering a more traditional cyclical downturn, and economic analysts are moving towards some sort of consensus view on what happens next. There is a widely held belief that corporates will be the next to suffer, with default rates set to rise in accordance with a more traditional economic downturn. As the wider economic environment becomes more familiar, and thus more predictable, credit analysts will be able to make more concrete judgements on when markets will reopen for new issuance.
But even in a more familiar environment, for those markets to reopen three things will be necessary, according to Dulake. First, the market needs more permanent or so-called sticky capital. The actions of the central banks have been paramount in achieving this to some small degree already. Secondly, the market needs some good news to help assuage negative sentiment. A recent rally in CDS spreads could fall under this category but the fact that cash didn’t follow indicates that there is still much uncertainty. Lastly, the return of the securitization market is vital in alleviating capital pressures. Of course, how securitization and structured products evolve from here is a huge question, and one that throws up challenges for everybody. "The engineering behind structured credit is too useful for it to end but it will evolve," says Juckes. "The whole space is fascinating. For research teams, how we analyse that is fascinating."
Fascinating it might be; demanding it certainly is. When absent investors do start returning to the market, the demand for comprehensive, accurate research will be higher than ever. Those houses that have shrunk their research capacities could well discover that they have a lot of ground to recover in order to stay relevant. "That credit research is more important than ever should be blatantly obvious from the last six months," says Juckes. "Where there’s massive risk, there’s massive opportunity. You’ve got to be able to navigate that."