The Greek Parliament late last month approved a massive bond-swap bill — a move that prompted Standard & Poor’s Corp. to cut the country’s sovereign-debt rating from junk status to selective default — in response to a second, €130 billion ($174 billion) aid package that the International Monetary Fund and various member governments of the European Union approved. The measures are intended to help reduce Greece’s debt and stabilize its fragile economy as the country heads into a fifth consecutive year of recession; the European Commission projects a stunning 4.4 percent contraction in Greece’s real gross domestic product in 2012.
The deadline for bondholders to approve the swap is March 8; Greece could erase some €100 billion in debt, but they would lose roughly 70 percent of their investments. Still, that beats the alternative: losing 100 percent, which has been a growing fear among money managers. Rising demand for credit default swaps has driven up the price of insuring against sovereign default: The Markit iTraxx SovX Western Europe index, which tracks the CDSs of 15 countries and is a widely used measure of perceived risk, has surged more than 30 percent since July.
Many market observers believe that serious challenges remain — not only in Greece, but also in Italy, Portugal and other nations on the EU periphery. A key question is just how far policymakers are willing to go to avoid catastrophe, but the answer is far from clear. Last month central bankers and finance ministers from the Group of 20 industrialized nations rebuffed German Chancellor Angela Merkel’s attempts to convince them to contribute to the euro zone’s permanent bailout fund via the IMF. The group will revisit the issue next month at the IMF’s spring meetings in Washington. In the meantime, uncertainty remains the order of the day.
“Following and understanding political developments in the EU periphery and the potential market impact of the various EU and European Central Bank economic policies and funding schemes are critical components of any investment thesis,” observes Michael Maras, who oversees global credit and global emerging-markets fixed-income research at Bank of America Merrill Lynch in London. “Political, legal and sovereign issues have overshadowed economics and fixed-income analysis and become the key driver of market valuations.”
The situation “compels fixed-income researchers to have a view on how the political landscape is likely to evolve before they can take a view on markets,” adds Terrence Belton, global head of fixed-income strategy at J.P. Morgan.
But even Charles Darwin would have a hard time charting the course of this particular evolution, given the scope of the problem and the sheer number of stakeholders that must approve any solution. “Our base case is that a combination of fundamental developments and the continued presence of backstops — the ECB and, increasingly, the IMF — will lessen the effect of the current crisis on bond markets, rates and the real economy somewhat,” explains Laurence Kantor, Barclays Capital’s New York–based global head of research. “That said, the crisis is not over, and there will be no ‘silver bullet.’ The environment will likely remain volatile.”
Money managers understandably want all the assistance they can get during these trying times. The guidance they find most valuable is that provided by analysts at J.P. Morgan, which tops Institutional Investor’s All-Europe Fixed-Income Research Team for a second straight year. The firm wins 14 total team positions, two more than in 2011. BarCap rises one rung to second place, but that seemingly slight advance belies the U.K. bank’s stunning gains: It more than doubles its number of positions, from four to ten, with four of those teams ranked No. 1 in their respective sectors. Last year the firm had no first-place teams.
BarCap’s rise bumps Deutsche Bank down one notch to No. 3, even though the Frankfurt-based financial services firm enjoys its own admirable additions — capturing three more team positions, for a total of nine. BofA Merrill is the biggest upward mover, leaping from No. 7 to tie for fourth place with Morgan Stanley; the firms each claim six positions, up from one and four, respectively, in 2011.
The table to the right highlights the analysts and teams ranked No. 1 in each of the 16 sectors that produced publishable results this year; squads in second and third place, along with runners-up, can be found on our website, institutionalinvestor.com.
The increase in total positions is attributable in part to a surge in voter participation. Last year’s results reflected the opinions of roughly 300 individuals at some 200 institutions managing an estimated $3.5 trillion in European fixed-income assets; this year nearly 550 respondents weighed in from more than 300 institutions managing about $5.5 trillion in those assets. The ballot was unchanged from last year’s.
“Client demand for high-quality fixed-income research remains extremely strong,” affirms J.P. Morgan’s Belton, who is based in Chicago. “Interest is focused as much on analysis of the sovereign and political landscape as on executable trade ideas.”
He adds that a growing number of clients have been requesting a regional sovereign-debt benchmark that excludes some of the weaker peripheral countries. “J.P. Morgan responded by introducing new indexes such as the high-grade European sovereign index,” Belton says. “Additionally, we have invested significant time and effort in analyzing sovereign and political risk to help our clients navigate the crisis. Our analysts have published a book that includes over 30 longer-shelf-life articles we have written on the most important aspects of the crisis.”
Other research directors report similar trends. “Macro issues have become relevant for investors across all asset classes, not solely those running macro strategies,” notes BarCap’s Kantor. “The value we add to our clients is primarily in our strategic assessment of fundamentals, but there is a strong need for tactical advice.”
Connecting the dots between macro concerns and sector-specific research continues to be a dominant theme. “Our reports and conference calls on bank deleveraging stand out,” he adds. “This topic, typically of interest to credit and equity bank analysts, acquired macro significance during the crisis, and we ensured that sector analysts collaborated with our rates strategists and economists to cover all angles. Equally, macro events influence trading levels of specific securities and indexes — being able to use the macro view to identify single-name opportunities has become increasingly important.”
Researchers also must keep clients up to date on developments in a rapidly changing environment without losing their longer-term perspectives. “We have published pieces that span the whole spectrum, from daily ‘Instant Insights’ as governments resigned and new countries were downgraded, to thematic and prescriptive pieces about how to leverage the European Financial Stability Facility or how to estimate how much it would take to save Italy,” Kantor says. The firm recently produced its 57th annual “Equity Gilt Study”; this year’s edition analyzes the scarcity of “safe” assets and its significance for long-term equity prices.
“It’s not only a question of what we publish, but how we bring our ideas to clients,” he adds. “Last year we hosted conference calls on the European crisis on an almost monthly basis, with over 9,000 participants in total.”
Educating investors is also a top priority at BofA Merrill, according to Maras. “We have seen a material increase in demand for thematic and cross-asset analysis, as well as in-depth educational research analyzing the impact of new policies and regulations,” he says. Among the topics the researchers have addressed are the ECB’s long-term refinancing operation, or LTRO, Greece’s private sector initiative, sovereign CDSs and more.
The firm has also witnessed an increase in demand for corporate credit research. “The deleveraging process of Western European banks has forced corporates to return to bond markets for their funding needs, while the search for yield has sustained the rapid growth of assets under management in high-yield and emerging-markets corporate credits — and attracted new issuers,” Maras says.
The sheer volume of corporates seeking credit has been staggering, notes Richard Phelan, Deutsche Bank’s head of European fixed-income research (and leader of the No. 1 team in High-Yield Basic Materials for a second consecutive year). “The most challenging aspect of publishing has been to keep up with the growing number of companies in the bond market, following upon two years in a row of €30 billion-plus in new deals, presenting plenty of opportunities to look at issuers without research coverage,” says Phelan, who is headquartered in London. “The level of interest in European high yield continues to grow, especially from U.S.-based fixed-income accounts, traditionally equity-focused fund managers and high-net-worth brokers searching for yield.”
Keeping pace with surging demand — especially in a time of high market volatility — is no easy task. “We are constantly exploring new ways to communicate our message,” he says. The firm has increased the number of road shows in which its analysts participate and expanded its use of technology. One example: In May Deutsche Bank launched an iPad application in conjunction with markit.com that delivers research to clients.
One thing that all investors require is a reliable performance benchmark. “Market-value-weighted indexes are the standard in both the fixed-income and equity index spaces,” explains Waqas Samad, the London-based leader of BarCap’s top-ranked team in Bond Markets Indexes. Even so, “it’s clear that investors and asset managers alike are looking for alternative ways to build benchmarks that reduce issuer concentration risk — including, for example, the recent changes in perception of issuer creditworthiness and other fundamental drivers of risk and return.”
In July, BarCap unveiled a new rules-based sovereign indexing methodology based on fiscal strength as measured by real GDP growth, debt-to-GDP ratio, dependence on external financing, market capacity and other factors. “Our model offers unbiased, intuitive and replicable benchmark indexes that we feel directly address concerns that real-world bond investors would have when thinking about moving away from pure market-value weights.” Products already launched include the global Treasury fiscal strength weighted index and the euro Treasury fiscal strength weighted index. More products will follow later this year, he adds.
“We expect 2012 to continue to offer many challenges to fixed-income investors, whether they are passive or active managers,” Samad explains. “Regulatory changes that are under way will mean that investors and managers alike will have to continue to invest heavily in strengthening their risk management processes.”
Regulation has been a chief concern of those that invest in collateralized debt obligations, according to London-based Rishad Ahluwalia, who with Saul Doctor directs the J.P. Morgan quartet that takes first place in Credit Derivatives; Doctor also leads the No. 1 team in Quantitative Analysis.
“We have been following the issues — risk retention for CDO managers, bank and insurance capital rules, and so on — and shedding light on these rather opaque topics,” Ahluwalia says. “We have also been focusing on the relative value of our products to broader credit asset classes and suggesting trade ideas based on risk and reward, as clients have been very focused on this.”
Among the macro affairs weighing on investors’ minds are funding for European banks, U.S. GDP numbers and Chinese inflation, adds Doctor, who also is headquartered in London. (The team’s other two members are based in New York.) “Specifically, on the derivatives side, however, market participants have also been concerned about regulation and market structure,” he observes, citing the Dodd–Frank Wall Street Reform and Consumer Protection Act in the U.S. and the European Market Infrastructure Regulation, as well as the EU’s Markets in Financial Instruments Directive and new rules governing short-selling. (Last month the EU governments agreed on a framework for regulating Europe’s £444 trillion [$700 trillion] derivatives market; the European Securities and Markets Authority is expected to present an implementation proposal to the European Commission by September.)
“While the regulations are yet to be implemented, investors are preparing for them — most immediately for clearing in the U.S. and short-selling restrictions in Europe, both of which are likely to be implemented this year,” Doctor says. “Many EU investors are looking across the pond to see the impact of the new requirements on derivative products in the U.S. European investors, however, need to be aware that clearing is coming to the EU and that trading in derivatives is likely to become more expensive as a result.”
Cost is only one factor in the risk-reward analysis. Last year money managers were faced with three key issues: “First, understanding and evaluating the various policy responses emanating from Europe,” says Francis Yared, whose Deutsche Bank squad leads the lineup in Interest Rate Strategy for a second year running. “Second, understanding the medium-term drivers of the euro crisis and evaluating the risks of a euro zone breakup. Finally, formulating investment strategies with acceptable risk rewards given a very volatile and uncertain environment.” The nine-member team, whose members are based in London, Paris and Zurich, coordinated with colleagues across multiple disciplines — European economists, emerging-markets researchers, foreign exchange strategists and political analysts — to devise a likely response scenario and explain the actual decisions and their potential impact.
In late 2009, Yared adds, the crew constructed a twin-deficits model, examining current-account and fiscal imbalances in various EU countries, to help evaluate sovereign risk. “We took the view that as long as Italy and Spain are deemed to be solvent, the policy response will seek to preserve the euro zone,” he says. “This framework provided a stable basis to assess medium-term risks and investment opportunities. We adapted our trading recommendations, taking into account the investment constraints that some of our client base was facing — for instance, focusing on trades within risk categories such as Ireland versus Portugal, Spain versus Italy and so on — and the high level of volatility.”
The analysts’ view remains unchanged. “Italy and Spain hold the key to the euro, and so far we view them as being fundamentally solvent even though they face serious challenges,” Yared says. “However, we find that the risks associated with the twin-deficits position of France are not properly priced at the moment. We also view that core rates are generally too low and expect a partial normalization to occur early in the year.” Risks will increase, he adds, as markets confront the impacts of higher oil prices, a slowdown in economic growth, and upcoming elections in France and Greece.
Further trouble down the road is an opinion echoed by Yared’s colleagues Gilles Moec and Mark Wall, who co-pilot Deutsche Bank’s five-strong squad to a second consecutive first-place finish in Economics. “We expect some volatility around the spring as reforms in Italy may start creating political tension, Greek elections may not return a workable majority and French political developments may lead to a postponement of the fiscal compact’s ratification. However, we think that these developments are unlikely to trigger the kind of near-collapse episodes we went through last year,” says Moec, who works out of London. “The continuation of the recession into the first half is in our view unavoidable, but the European slowdown is idiosyncratic. The U.S. and the emerging markets are providing decent traction, which should ultimately lift Europe out of contraction, assuming the additional liquidity measures taken by the ECB gradually restart credit origination.”
Belton, the J.P. Morgan strategist, also sees problems looming. “We believe that the recent risk-on sentiment can continue for a while, spurred by the three-year LTRO at the end of February,” he says. “Going into the second half of the year, however, we believe that peripheral sovereign markets will start to underperform on the back of various risks such as negotiation of a new Portuguese bailout package, recession in the peripheral economies and bank balance sheets getting too full of sovereign paper. We are therefore positive on risky assets near term — but would be careful going into the second half of this year.” • •
