The world of fixed-income investing has offered up more than enough reasons for investors to feel skittish. In the latter half of the last decade, credit markets began to change dramatically. First, trading volume surged as those markets, particularly in Europe and the U.S., were flooded with highly rated securitized products, which were often backed by subprime mortgages and other assets that turned out to be toxic.
Then, in 2007 and 2008, as a bubble in the U.S. housing market was rapidly deflating, many banks were so highly leveraged and heavily laden with subprime debt that eventually they stopped lending — even to each other. The frozen credit markets began to thaw only after governments around the world pledged trillions of dollars in assistance and economic stimulus packages. But just as the corporate-debt markets began to show signs of returning to normalcy, trouble erupted in the sovereign-debt markets — first in Dubai, then in Europe.
In the wake of Greece’s near-default last spring and Ireland’s request for financial rescue in November, plus ongoing fears about the creditworthiness of other countries with soaring deficits, demand for European fixed-income research skyrocketed.
“Most clients see the world as incredibly risky given the size of fiscal deficits in Europe and the U.S.,” observes John Normand, global head of foreign exchange strategy at J.P. Morgan.
Which banks provide the guidance that money managers find most helpful as they seek to navigate these risks in search of investment rewards? No one does it better than J.P. Morgan, according to participants in Institutional Investor’s 2011 All-Europe Fixed-Income Research Team survey. The firm wins 12 total positions, including seven teams that are ranked No. 1 in their respective sectors. Deutsche Bank claims second place, with six positions; the German bank has five teams in first place. Barclays Capital and Morgan Stanley tie for third, with four positions each.
At the same time that the fixed-income marketplace was undergoing profound changes, many firms began to reconsider the way they cover these newly dynamic — and volatile — markets. Some firms have stopped publishing fixed-income research altogether and moved their publishing analysts to the trading desk so they can more directly serve their most active clients. Other firms have adopted the desk-analyst model in only certain sectors, and some have expanded their research operations after having scaled them back several years ago. (Only those analysts who publish independent research as it is defined by the Financial Services Authority are eligible to be recognized in our survey’s research sectors — for example, High Yield and Investment Grade. No such restriction applies in Economics & Strategy, in accordance with FSA regulations.)
Terrence Belton, global head of fixed-income strategy at J.P. Morgan, says his firm opted not to move any of its 40 European fixed-income analysts to the trading desk: “Our commitment to publishing research is as strong as ever.”
As default risk in Europe’s sovereign markets has catapulted to the top of the list of investor concerns, he adds, his department has benefited from increased collaboration among its analysts who specialize in emerging markets, interest rates and macroeconomic issues. “Having that breadth of coverage has been really important over the last year or two, particularly in staying ahead of the sovereign crisis,” says Belton, who is based in Chicago.
This emphasis on cooperation has not led the firm to add analysts; instead, “it’s a different kind of research that’s being published,” he explains. “For example, our rates research has had to refocus a bit and think about government bonds in a way that we haven’t had to in the past.”
Drawing on information from colleagues on the relative strength of European economies and the sovereign-debt situation, the firm’s top-ranked Currency & Foreign Exchange team, directed by Normand, told clients that the euro would underperform the region’s currencies. They were right. “At the beginning of 2010, the euro versus Norway was around 8.4, and at the end of the year, it was around 8.1. So the euro had declined pretty substantially,” Normand says. “There was a similar move in Sweden — the currency was around 10.3 early in the year, and we anticipated that the euro would fall to around 9.5. It ended the year at 9.3, so Sweden appreciated considerably.”
Deutsche decided to follow a different path with regard to publishing versus desk analysts. In 2007, as fixed-income trading volumes soared, the firm relocated its five European investment-grade securities researchers to the trading desk; it already had 11 distressed-debt analysts on the desk. (Deutsche’s five high-yield analysts stayed put and continue to publish research.)
“Historically, there’s been a lot less volatility among investment-grade entities, and there’s significantly more volatility as you go down the credit scale,” according to Richard Phelan, head of European fixed-income research and leader of the No. 1 team in High-Yield Basic Materials. “In investment grade the impact of the research we published was relatively limited — there weren’t big credit changes that were occurring, and the calls were much more macro-oriented — so being close to the desk and the trading flow makes more sense.”
Phelan acknowledges that if volatility in Europe’s debt market returns to historic norms, some of those analysts could be moved off the desk and back into a publishing role, but, he says, “we at Deutsche Bank feel that it works in investment grade, and I absolutely don’t think that we’ll change that anytime soon.”
Among Deutsche analysts who do publish, James Reid achieves a rare accomplishment: He leads not one but two teams that finish in first place: General Strategy and Investment-Grade Strategy. In December 2009, Reid and his associates published a comprehensive outlook for the year ahead that included general strategy, high yield, investment grade and leveraged finance. The analysts noted that “history is littered with examples of inflation, devaluations and sovereign defaults after financial crisis” and alerted clients that “we continue to run the risk of sovereign land mines disturbing the benign corporate landscape.” Four months later one of those land mines exploded, in Greece.
The team also predicted that in the high-yield space, issuance would be robust, owing to low rates and demand’s outpacing supply — but the high-yield market in the U.S. would be even better, because it’s larger and more liquid. “We expect U.S. high yield to outperform the European high-yield market” and the latter to outperform European investment grade on a total as well as excess return basis, the analysts said, and they were right: U.S. high yield advanced 14.2 percent last year, compared with 12.3 percent for European high yield and 4.7 percent for European investment-grade, Reid says.
Rising demand for fixed-income investments prompted BarCap to add to its analyst head count. “We see a real opportunity in the credit business in Europe,” says Laurence Kantor, BarCap’s New York–based global head of research. In October the firm added three high-yield analysts to its Europe fixed-income team, bringing its total to 99. BarCap also has two desk analysts covering high yield and investment grade.
Eric Miller, who heads up BarCap’s global credit research operations, says the expansion was prompted by signs of growth in the market. “We saw tremendous issuance in 2010 in Europe, and we expect that trend to continue,” says Miller, who is based in New York. “Companies and investors are yearning to get more public corporate securities into the market, since it just makes sense to get that out of the hands of the banks. We’ve taken a very direct strategy to ensure that we have the best credit strategists and analysts on the ground in the region to support this trend.”
Morgan Stanley also noted the potential in the market and has been expanding its research operations. “Over the past 12 to 18 months, we’ve made a concerted effort to rebuild the franchise, to bring in key people and key products,” says Gregory Peters, the firm’s New York–based global head of fixed-income research. “We don’t want to be all things to all people, but in the spaces that we’re in, we want to be relevant.”
Research is now central to the firm’s client-service efforts, and Peters concedes that wasn’t always the case. Morgan Stanley made a decision five years ago to limit what it does in the way of publishing, he says, but has since reconsidered that stance. “You have to have consumable research to reach the clients in a meaningful way,” Peters explains.
The bank added ten European publishing analysts last year, for a total of 55; it also has five desk analysts covering distressed debt and eight in high yield and investment grade. Among the recent hires is Marcus Rivaldi, who joined the firm in June 2009 from Royal Bank of Scotland to cover insurance companies as part of Morgan Stanley’s Banking & Financial Services team. That team, captained by Zurich-based Jacqueline Ineke, takes top honors in the sector thanks in part to a bold, contrarian call in November 2009 to overweight tier-1 bonds issued by European banks.
The analysts predicted that Basel III, which would not be unveiled for nearly a year, would introduce new rules for tier-1 bonds — namely, that the bonds must be loss-absorbing on a going-concern basis. “Old tier 1s do not have this characteristic, and so under the new Basel III rules, these old tier 1s would not be compliant,” Ineke explains. “In our view banks would want to redeem them as soon as they could, which means at par at the first call date, or would tender or exchange at a premium to market price. This implied very good returns on a yield-to-call basis of between 10 and 20 percent.”
Other analysts disagreed, believing that Basel III would include a grandfather clause for current tier-1 bonds that would mean banks would leave them outstanding. When the new standards were announced in September, the Morgan Stanley team was proved right. By then more than 70 bank capital instruments had been called at par, including tier-1 bonds issued by Britain’s Standard Chartered, France’s Société Générale and Sweden’s Nordea Bank and Swedbank.
The Basel III requirements are meant to strengthen banks’ capital positions, avoid a recurrence of the events that plunged the world into the worst economic crisis since the Great Depression and restore investor confidence. That last objective may prove to be a formidable task, given the ongoing concerns about sovereign-debt default in Europe. “Investors’ preoccupation with extreme events and sudden market declines is going to persist for quite a while,” says J.P. Morgan’s Normand. But the analysts on the 2011 All-Europe Fixed-Income Research Team will be standing by to guide those investors through whatever turbulence lies ahead.
