In a January speech to frankfurt’s chamber of commerce, European Central Bank president Mario Draghi declared that “the darkest clouds over the euro area subsided” in 2012. Many market observers agree — and credit Draghi’s July declaration that the ECB would do “whatever it takes to preserve the euro” with calling forth the necessary sunshine to dispel the gloom. Words alone would likely have had little effect, but the bank followed up with the creation of Outright Monetary Transactions, a program through which it would buy the bonds of member countries, in effect becoming a lender of last resort.
These moves appear to have removed much of the negative overhang weighing on European markets, paving the way for double-digit returns for the region’s high-yield, investment-grade and sovereign debt offerings. Since the as-yet-untapped OMT was introduced in September, the bonds of some of the euro zone’s most troubled economies — Greece, Ireland, Italy, Portugal and Spain — have risen by 11 percent or more, through mid-February. But Europe’s economic situation is still precarious, and any number of potential shocks could widen spreads and dampen returns. Moreover, policymakers have yet to address the region’s long-term growth prospects.
One key issue for analysts and investors is determining whether the current calm is going to last. Laurence Kantor, Barclays’s New York–based global head of research, believes it will. “You’ve seen a rally in nearly all the European markets since last summer — stocks, bonds in all kinds of sectors — and the negative tail risk has fallen,” he says. “Policymakers have taken other actions before, but the ECB’s latest action has lasted much longer than the other respites from market turmoil, and we do think it has staying power. But if something happens that would upset the market, tail risks could rise once again.”
Michael Maras, head of global credit and emerging-markets fixed-income research at Bank of America Merrill Lynch in London, provides an example. “The major theme behind investor thinking right now is the assumption that both U.S. and the European Union monetary policy will remain highly accommodative in 2013,” he says. “Now, if you would tell me tomorrow morning that suddenly the U.S. Federal Reserve Board has come out with an announcement that it’s backing off on providing central bank liquidity because it’s getting concerned about long-term inflation expectations and becoming more hawkish, I think that would be the catalyst for a new wave of volatility.”
Money managers appear to be taking less-dramatic developments in stride. Although many investors are anxious about the outcome of Italy’s elections, fearful that an antiausterity government will come to power and plunge that country back into crisis, market reaction was largely muted last month after Moody’s Investors Service downgraded the U.K.’s triple-A sovereign debt rating; the pound slumped against the dollar and the euro, but U.K. bond yields held steady. Buy-siders were unfazed by the rating reduction because they had expected it: Moody’s had placed the U.K. on its negative outlook list back in February 2012, a move that was subsequently matched by both Fitch Ratings and Standard & Poor’s.
Keeping investors abreast of developments and their likely impact — on the upside or the down — is what sell-side research departments do, and none does a better job of providing insight and guidance to investors in European fixed-income securities than J.P. Morgan, which leads Institutional Investor’s All-Europe Fixed-Income Research Team for a third straight year. The firm captures 17 total team positions, three more than last year and three more than Barclays, which repeats in second place even though it increases its team total by four.
BofA Merrill climbs from fourth place to third, but that modest advance belies the firm’s stunning gains: It more than doubles its number of team positions, from six to 13. Down one notch to No. 4 is Deutsche Bank, which picks up three spots, for a total of 12. Rounding out the top five is Morgan Stanley, which tied for fourth place last year; it increases its total by one, to seven. Survey results reflect the views of nearly 800 individuals at some 380 institutions globally that manage an estimated $6.4 trillion in European fixed-income assets.
This year’s 18 top-ranked teams are cited in the table on the opposite page. Deeper data, including profiles of the crews that rank first, second and third in each sector, can be found on our website, institutionalinvestor.com.
Joyce Chang, who became J.P. Morgan’s global head of fixed-income research in December, says her firm has been making selective hires across the whole franchise but especially in emerging-markets corporate research in eastern Europe, the Middle East and Africa. The expansion will continue, she adds, because emerging-markets corporate issuance is on the rise — hitting $333 billion in 2012, up from $211 billion the year before, and racking up $51 billion in January 2013 alone. Meanwhile, assets benchmarked to J.P. Morgan’s emerging-markets corporate bond index surged from $29 billion at the end of 2011 to some $50 billion at the end of last year, notes Chang, who works out of New York.
Barclays has also “really ramped up our European offering,” according to Kantor. Some of the analysts who joined the firm in recent years appear on this year’s roster: Christophe Boulanger co-leads the two No. 1 teams in Manufacturing/General Industrials, sharing oversight responsibilities with Darren Hook in investment grade and with Thomas Southon in high yield. Karine Elias helms the Retailing/Consumer Products crews that rank second in high yield and third in investment grade, and Daniel Rekrut (with Jonathan Horner) takes third in High-Yield Technology, Media & Telecommunications. In addition, Philippe Gudin de Vallerin joined Barclays in July as chief European economist from the French Ministry of Economics and Finance, where he served as director of macroeconomic policies.
It’s important to have more analysts in place, Kantor says, to cover more credits not only as the market evolves but also as companies change the way they access funding. “The bulk of credit flows in Europe has always gone through banks, whereas in the U.S. the bulk goes through the financial markets — through the corporate bond market and commercial paper market,” he explains. “This is changing in Europe. It is a natural evolution as the credit markets have developed, and it’s been accelerated by the troubles that European banks are having. They’re having to strengthen balance sheets, deleverage and hold more capital.”
BofA Merrill has no “aggressive” expansion plans in terms of analyst head count, Maras says, but the firm is seeking to broaden coverage of global emerging-markets corporate credits. “We have the capacity to do that because of the investments we made over the past three years,” he points out. “We kind of thought this is the way things would evolve and, therefore, we are well positioned.”
The rise in corporate credit issuance is helping to keep cross-asset-class analysis in high demand, Maras adds, and roundtables organized by sell-side research firms continue to illuminate investors’ understanding of the world in an integrated manner. Jeffrey Tannenbaum, who oversees distribution of debt products at BofA Merrill, moderated a December panel in London, “2013: Our Expectations for a Stabilizing Europe,” that included equity analysts as well as Laurence Boone, the firm’s head of developed European economics; Barnaby Martin, head of European credit strategy; and Ralf Preusser, head of European rates research.
Members of Barclays’s macroeconomics and fundamental teams also gather for roundtable dinners and bespoke events focused on topics such as global banks and relative value in the European and U.S. high-yield markets, according to Rekrut. “The account base now is looking up and down the ratings curve and across the capital structure,” the London-based analyst explains. “It’s very powerful to have products with the fundamental credit view as well as the equity view.”
The relative calm currently enveloping Europe has multiple beneficiaries, including the euro, according to London-based Muhammad Umar Bilal Hafeez, who guides the 12-strong Deutsche Bank squad from third place to its first appearance on top in Currency & Foreign Exchange. The team is “quite constructive on the euro, mainly because the fears of a crisis in the euro area are much less now, and we think they’ll continue to decline in the next three or four months,” he says. With growth stabilizing in the region, Hafeez believes, foreigners will likely buy European bonds — another supportive move for the currency.
As for speculation that Japan is waging a currency war because the yen has weakened remarkably, falling in value about 20 percent against the dollar over the past three months, Hafeez feels such concerns are overblown. “What the Japanese are doing is very specific to their economy, which has been mired in deflation for a long, long time,” he says. “Outsiders have constantly told them to do something more aggressive. They now are doing something more aggressive” — for example, in January the Bank of Japan announced that it would buy ¥10 trillion ($112 billion) in government bonds and other assets each month as part of a plan to overcome deflation — “and one of the consequences of that has been a weaker yen.”
Laurence Mutkin, leader of the eight-member Morgan Stanley crew that catapults from runner-up to No. 1 in Interest Rate Strategy, notes that determining the outcome of the euro zone crisis is less important than figuring out what to do in the meantime. “Even if you’re right about the endgame, the volatility of the market is such that your positions will be stopped up before you get there,” he asserts. “What you really have to do is come up with ways of generating alpha during the middle game, like now. There are relationships in bond markets that have to hold true, and if those relationships begin to come out of line, that’s where you have an opportunity to add alpha without having to be right about the endgame.”
To that end, the London-based team is using principal component analysis, or PCA, to study relative value across sovereigns and within sovereign curves, comparing the steepness of the credit curve to the level of the credit spread. Mutkin and his associates developed their PCA model in April to enable them to “see in each individual sovereign’s bond yields how much of the spread is idiosyncratic and how much is just a representation of the overall systemic level of risk,” Mutkin explains.
What they’ve discovered is not encouraging. More bearish than many European analysts, the Morgan Stanley researchers published a report last month in which they noted that funding costs are rising but nominal real gross domestic product growth is not. “Higher funding rates are simply not good news for highly leveraged borrowers, and euro area sovereigns’ debt levels are all high (indeed, higher than in 2011 and 2012),” they wrote. “Therefore, there’s reason to start worrying now, especially as the pricing of systemic sovereign risk is back at first-half 2012 lows, according to our PCA-derived measure.”
That concern is shared by the London-based Barclays Quantitative Analysis team co-captained by Albert Desclée and Arne Staal, which also rockets from runner-up to the sector’s top spot. “Managing sovereign spread risk has in recent years become one of the most important performance drivers of European fixed-income portfolios, and we expect this to continue,” Desclée says.
“People are much more focused on understanding the systematic drivers of risk. They’re looking at that from a construction perspective, a risk-management perspective and a search-for-yield perspective,” Staal adds. “The search for yield has led to strong interest in alternative beta and systematic alpha investment strategies.”
Such repositioning has also raised concerns about whether money will continue to pour into credit, given the fact that the major fixed-income asset classes enjoyed $350 billion of inflows last year — more than triple the amount in 2011, according to BofA Merrill chief Maras.
J.P. Morgan’s Chang, while agreeing that this growth rate is not sustainable, believes that inflows will continue, albeit further down the ratings spectrum. The firm’s most recent quarterly survey of fixed-income investors, which was conducted in late January, revealed that since the previous poll allocations to double-B credits had fallen from 40 percent to 37 percent of the average portfolio, while exposure to high-yield single-B assets had risen by about 5 percent, to 50 percent.
“The key concern we’re hearing from investors is that risk-free rates have risen materially,” explains Chang, referring to developed-markets bond yields. “That’s going to drag down corporate bond returns, which are negative year-to-date for the European high-grade market,” through mid-February.
Richard Phelan, Deutsche Bank’s London-based head of European fixed-income research (and leader of the top team in High-Yield Basic Materials for a third year in a row), confirms that “high yield is still benefiting from strong inflows, while investment-grade yields are more precarious. Our view has been that the technical strengths supported by the inflows will probably contribute to good performance into European credit markets long into the first quarter of 2013, and then there will be some greater uncertainty thereafter.”
Uneasiness will likely persist until a new framework — enforceable fiscal rules, unified oversight of banking operations and a common bond market — is put in place, observes Barclays’s Kantor, but “that would take years, and markets aren’t that patient.”
Another concern, contends Maras, is the potential for dashed expectations about fiscal and structural reforms, particularly in France and Spain. Many market observers assume that the latter nation will request funding assistance from the ECB. “If that doesn’t happen, you can easily make the assumption at some stage that the financial markets may become worried about it, and you’ll start seeing Spanish rates rising dramatically in a very short period of time,” he says. “So the timing is absolutely critical. The longer they delay reaching out to the ECB, the more investors will become edgy. What happens if it’s suddenly the second quarter and people think, ‘What’s happening here? Maybe we should start shorting Spain.’”
Investors have similar questions about France and whether that country is truly committed to long-term fiscal reforms, Maras adds.
Lasting stability is one issue that central bankers have yet to address. “The ECB has gone a long way in terms of addressing any kind of short-term liquidity shocks that there might be in Europe,” observes James Reid, who directs the Deutsche Bank trio that finishes first in General Strategy and Investment-Grade Strategy for a third year running, climbs from second to first in High-Yield Strategy and debuts at No. 2 in Credit Derivatives. “What it hasn’t done yet is address growth concerns. There’s nothing that the ECB has done that has notably changed the trajectory of growth in Europe.” It’s important to see “whether 2014 and 2015 growth numbers look vaguely normal or, alternatively, whether we are still in some long structural decline for several peripheral countries,” adds Reid, who works out of London. “If economists are too optimistic on growth in 2014 or 2015, maybe we’ll have to think about even more extraordinary measures to keep Europe afloat. Maybe the ECB might eventually have to embark on full quantitative easing in a similar manner to the Fed. This is still a long way off — but not impossible.” • •