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Rising interest rates notwithstanding, debt markets have been uncharacteristically calm, while the lives of fixed-income analysts have been anything but. One development lies behind both outcomes: the growing popularity of credit derivatives. Increasing demand for these instruments — the notional value of contracts outstanding exceeds $17 trillion, up from virtually zero just one decade ago — is making analysts’ jobs more challenging. Credit derivatives, which essentially offer investors protection against companies’ defaulting on their debt, are increasingly being used as part of complex strategies by hedge funds and other institutions. Analysts, consequently, must understand this market and its impact on the corporate bonds they cover to provide truly comprehensive advice to clients. Surging derivatives use has even been a factor in some banks’ decisions to restructure their research departments. Many firms have assigned analysts to roles on their trading desks, where they work internally with traders and advise just a handful of important clients. Others are merging previously separate departments within research, for example combining equity and fixed-income coverage.
The phenomenon’s effect on debt markets has been far more benign. Events that not long ago would have caused ructions — interest rate hikes, rising oil and commodities prices, equity volatility and geopolitical turbulence — have created barely a ripple this year. As of mid-August the yield on the benchmark ten-year U.S. Treasury note sat comfortably at 4.9 percent, only slightly above its 4.4 percent resting place one year earlier, despite predictions that concerns about the economy would drive bond prices down much further.
“There are more tools these days for people to express and hedge their positions, especially with the growing use of credit derivatives,” says Daniel Spina, head of fixed-income research for Bear, Stearns & Co. in New York. “Managers are much more experienced at handling event risk than in the past, having faced many unique and shocking events over the past several years.”
One such event was last year’s turmoil in the auto industry, which appears to have been the tipping point for the transition of credit derivatives from a niche product into the mainstream. In May 2005, Standard & Poor’s downgraded General Motors Corp. and Ford Motor Co. credit to junk status, a move affecting $450 billion in bonds and, it was feared, one that would cause panic selling and steep investor losses. That didn’t happen, because the credit derivatives market had anticipated the bad news and priced credit default swaps, the most popular type of credit derivatives, accordingly.
As more investors embrace credit derivatives, they increasingly seek shrewd advice from Wall Street analysts about what strategies to pursue. Consequently, determining which researchers provide the best counsel has become more important than ever. Institutional Investor sets out to do just that every year, through our All-America Fixed-Income Research Team survey. This year, even as the requirements of the job are changing, the cream of the crop is not. For a seventh year in a row, the analysts at Lehman Brothers have been judged the best in the industry by the nearly 1,250 portfolio managers and buy-side analysts who responded to the poll. Lehman garners 41 total team positions — two more than last year — including 18 first-team positions, a 50 percent increase over the 12 the firm captured in 2005. J.P. Morgan returns in the No. 2 spot overall, with 37 total team positions (one fewer than last year) and nine first-team spots. Bear, Stearns & Co. is No. 3, up from No. 5, with 24 total team positions, up from 20, and three first-teamers (four fewer than last year). UBS remains at No. 4, with 23 total team positions, two more than last year, and nine first-teamers again this year. Finishing in the top five for the first time is Banc of America Securities, whose increase of four total team positions, to 21, propelled it from seventh place. The biggest movers into the top ten are Goldman, Sachs & Co. (which rises from No. 11 to tie for No. 7), RBS Greenwich Capital (No. 14 to a tie for No. 9) and Wachovia Securities (No. 13 to a tie for No. 9).
This year’s survey, our 15th, covers 63 categories. Two formerly separate bank categories — Banks/U.S. and Banks/Global — have been merged. In addition, we have created two new categories: Investment-Grade Technology, in recognition of the fact that many of the bigger companies in the sector are now issuing high-grade debt; and a Quantitative Portfolio category, acknowledging the work that many firms are doing to bridge equity and fixed-income analyses.
Eric Beinstein, who leads J.P. Morgan’s team to a first-place finish again this year in coverage of Credit Derivatives, says derivatives now account for nearly half of his firm’s trading in credit and are changing the way analysts do their jobs. “While the basic job remains unchanged — having a view on whether or not the credit of a company is getting worse or better — what credit derivatives allow analysts to do is provide more relative-value analysis and advice on whether to go long or short the risk in a given company,” says the New York–based analyst.
That’s because default swaps provide a simple, straightforward means for comparing bonds. Unlike stocks, which are structurally uniform, bonds have a variety of moving parts — different coupons, maturities and covenants — which make them harder to compare with one another, even when they are from the same issuer. Default swaps allow for more direct comparisons because they focus on a single factor — credit quality — and not multiple variables such as price, yield and duration. “They’ve become the benchmark,” says Jeffrey Skoglund, who returns in first place for his coverage of High-Yield Manufacturing/Automotive Supplies for UBS in Stamford, Connecticut.
For researchers, knowing the nuances of credit derivatives has become essential. “Analysts who understand both the cash and derivatives dimensions of credit can identify more trading ideas for their investors,” says David Heike of Lehman Brothers in New York, who leads the top-ranked Investment-Grade Strategy team. “[Recommending derivatives] also forces analysts to understand both the fundamental and technical aspects across sectors and to take a more quantitative approach to analysis.”
The heightened interest in derivatives, which encourages investors to take a more holistic view of companies, is even having an impact on how research departments are structured. At J.P. Morgan, for instance, credit and equity analysts have been aligned to focus coverage on individual corporate names, not securities structures. Bear Stearns has integrated its previously separate coverage of investment-grade and junk-rated companies.
“Because growth in credit derivatives has increased the ability of investors to change exposures across the fixed-income markets and as part of cross-sector strategies, traditional credit analysis needs to focus more on a broader set of instruments, to integrate credit with equities and derivatives,” says Terrence Belton, head of U.S. fixed-income strategy and global derivatives strategy for J.P. Morgan in Chicago, who leads the returning top team in the Interest Rate Derivatives category and co-leads the third-ranked General Strategy team. “It is this need for expertise in all three areas that has driven the realignment of our research teams and those at other firms.”
Adds Bear’s Spina: “Our analysts cover companies and sectors. For example, if an investment-grade issue falls into high-yield territory — or it gets upgraded — then their company knowledge is not lost.” This approach allows the firm’s analysts to more effectively meet the needs of its clients. “If you have $100 million to invest, you should not have to talk to three people to get an overview of the markets,” he says.
Not all firms are responding this way, however. UBS, for instance, is encouraging analysts from different disciplines to cooperate without formally merging coverage. “We recognize capital-arbitrage ideas need to happen, but we do not think merging departments is necessarily the answer,” says Charles Mounts, co-head of fixed-income research at UBS in New York.
Firms are far less willing to talk about the phenomenon of the so-called desk analyst. During the past few years, nearly every big brokerage house has dedicated fixed-income researchers to trading-desk roles. Rather than publish research for all clients, these analysts provide ideas only for the firm’s in-house traders and an elite group of investors. Banc of America Securities, for instance, shifted coverage of some macroeconomic sectors to desk analysts two years ago. UBS also has assigned some researchers to desk positions. “Sometimes desk analysts can do things publishing analysts cannot,” says Laurie Goodman, co-head of fixed-income research for UBS in New York. Among these tasks: real-time analysis of market conditions and opportunities. Neither BofA nor UBS will specify the numbers of desk analysts versus publishing analysts — a position taken by virtually all of their major competitors.
The move toward desk analysts has created a delicate situation for Wall Street. Brokerage houses don’t want the ideas and advice generated by researchers assigned to trading desks to be construed by clients as being investment research in the traditional sense. That’s because published research is subject to greater regulatory scrutiny than the less formal advice that trading desks provide. The Bond Market Association, an industry trade group, issued guidelines in 2004 urging firms to clearly identify any commentary and trade ideas produced by desk analysts as being distinct from the work of publishing analysts. A further issue surrounding the desk analyst phenomenon: The biggest, most lucrative trading clients essentially get special treatment because desk analysts cater to them, but smaller clients suffer when publishing analysts are taken out of circulation to perform trading-desk jobs.
Research heads at big sell-side firms insist they are still committed to publishing research even though they have diverted resources to trading. “We strongly believe our clients value the depth of our reports, and we continue to provide full publishing capabilities,” says J.P. Morgan’s Belton.
Firms are also encouraging publishing researchers to provide all clients with the kind of analysis desk personnel are making available to big customers. Paula Dominick, global head of debt and equity research at BofA in New York, has pushed publishing analysts to deliver one-page analyses and recommendations whenever needed, rivaling the speed of delivery offered by desk analysts. “We can get our reports out in about 15 minutes,” she says. UBS’s Goodman, who leads or co-leads the No. 1 team in five mortgage-backed-securities categories (upping the total from four last year), says firms don’t necessarily need desk analysts to generate and disseminate executable trade ideas: “We think publishing analysts should do that as well,” she explains.
The inevitable result of the move toward desk analysts will be less published research, and that will make markets less efficient for all investors. “There will be less information, with less of it publicly disseminated,” says Ravi Mattu, global head of equity and fixed-income research at Lehman in New York. “Reducing the flow of public information is not a positive development for investors.”
Buy-side survey participants seem to agree. When II asked how they felt the quality of sell-side research has changed over the past year, nearly half — 45 percent — said it had deteriorated. That’s up sharply from last year, when 25 percent said the quality of research had declined from the year before. Still, nearly 75 percent of respondents this year said they were at least “somewhat satisfied” with brokerage firm research. A complex picture — not unlike the challenge facing today’s fixed-income analysts.
