At this time last year, directors of U.S. fixed-income research were cheering the first signs of life in a market that only a few months earlier had seemed so toxic, many wondered if it would ever see growth again. In recent months, however, those green shoots have withered. A dearth of securitized products, fears of sovereign-wealth crises spreading and a sluggish U.S. economic recovery have spooked many fixed-income investors.
“What took us by surprise was the strength of the negative reaction to events in Europe this spring and the degree to which economic data has softened more recently,” says Peter Hooper III, chief U.S. economist for Deutsche Bank in New York.
In response to the bad news at home and abroad, “investors who’ve traditionally had more of a U.S. and developed-market focus have had to think more about investing in emerging markets,” explains Joyce Chang, New York–based global head of J.P. Morgan’s credit research department and director of its emerging-markets coverage.
This shift in focus has prompted many banks to reconsider their approaches to U.S. fixed-income research, and money managers say no firm does a better job of meeting their changing needs than J.P. Morgan, which rises one rung to claim top honors in the 2010 All-America Fixed-Income Research Team survey.
J.P. Morgan captures a record 55 team positions — 13 more than it won last year, including seven more first-place positions — and bumps down to second place the research department that had ruled the roost for the past decade, last year as part of Barclays Capital and for the nine years before that as part of Lehman Brothers. (Barclays acquired the North American operations of Lehman Brothers Holdings in September 2008.) BarCap wins 49 total team positions this year, three more than in 2009 and up two from the previous record high of 47 it won in 2008.
BofA Merrill Lynch Global Research holds steady in third place even though it picks up six more positions, for a total of 40. Returning in fourth and fifth place, respectively, are Goldman, Sachs & Co., with 24 positions (two more than in 2009), and Wells Fargo Securities, with 15 (one more than last year). Results are based on responses from more than 1,100 buy-side analysts and investment officers at approximately 440 firms managing an estimated $8.9 trillion in U.S. fixed-income assets.
Terrence Belton, global head of fixed-income strategy at J.P. Morgan, also notes that investors are taking a broader view these days. “The global linkages are more pronounced this year than in the last couple of years,” says Belton, who is based in Chicago and leads the top-ranked team in Interest Rate Derivatives and, with Srinivasan Ramaswamy, the No. 1 team in General Strategy. (Analysts and teams ranked No. 1 in their respective sectors and the complete list of winners, including those ranked second, third and runner-up, click here.) “We’ve benefited a lot from the global nature of our franchise and our research team,” Belton adds.
Other firms are beefing up their global fixed-income franchises. BarCap hired Michael Gavin, formerly an emerging-markets economist with Citadel Investment Group, in August 2009 to direct its emerging-markets strategy; the firm also added analysts in Brazil and Russia to cover those burgeoning fixed-income markets, according to Laurence Kantor, global head of research in New York.
BofA Merrill restructured its research operations last year, consolidating all 30 of its emerging-markets fixed-income analysts into one team, to “intensify the generation of ideas and grow the dialogue across regions,” according to Michael Maras, the bank’s New York–based head of global credit and emerging-markets fixed-income research.
“In emerging markets we were primarily focused in equities — we were lacking on the fixed-income side,” Maras acknowledges. “The message we got from clients was, ‘You need to create a brand identity in that space and educate us.’”
J.P. Morgan’s Chang, who with Luis Oganes leads the top-ranked teams in Emerging-Markets Strategy and Emerging-Markets Sovereigns & Economics, attributes rising interest in emerging markets at least in part to a decline in structured securities and other instruments that appeal to risk-averse investors (see “Structured Market Ready to Grow, But ...”). J.P. Morgan estimates that the overall supply of credit products has dropped by $1.2 trillion since 2007, to $2.7 trillion, and net issuance of structured products in the first half of 2010 was $174 billion less than it was in the same period last year.
“With the drop in issuance in some of the securitized markets, investors have had to focus on newer products, such as emerging-markets corporates and Build America Bonds,” says Chang. Her team’s top picks in emerging-markets sovereign debt for 2010 include Indonesia and Mexico. The former returned almost 20 percent year-to-date through July and the latter 13 percent, Chang says.
Many fixed-income investors appear to favor emerging-markets instruments for gains and U.S. Treasury products for security and stability. Hooper, who with Joseph LaVorgna guides Deutsche Bank’s team to a first-place debut in Economics, believes that sovereign-debt problems in Europe — which have been sending many global investors to the perceived safety of the U.S. Treasury market — are being overplayed. Hooper predicts that as the fear around those risks begins to recede, the premium currently being placed on Treasuries will diminish — and that could have huge implications for the fixed-income market in general. The Federal Reserve’s benchmark overnight lending rate has been near zero percent since December 2008, its lowest level ever. As demand for Treasuries tapers off, the Fed will likely raise rates, sending the fixed-income market as a whole moving in a negative direction. But Hooper doesn’t see that happening anytime soon.
BarCap’s Michael Pond, who guides the No. 1 team in Treasury Inflation-Protected Securities for a third consecutive year, says demand for TIPS is soaring as investors seek the safety of U.S. government–backed bonds with a hedge against rising prices. “Investors look at TIPS from a long-term perspective — as inflation insurance, if you will,” explains Pond, who is based in New York. “Like any insurance, you want to buy it when it’s cheap.”
Over the past year, Pond adds, a rapidly growing demand base for TIPS has been foreign investors; in July, for instance, foreign investors bought more than half of the $12 billion in TIPS the Treasury Department offered, even though ten-year Treasuries outperformed comparable TIPS by more than 1.4 percentage points from January 2009 through July 2010. Foreign interest is driven in part by concerns that the U.S. government might try to inflate its way out of its soaring debt problem. Because the TIPS market remains relatively small — about $550 billion, or roughly 8 percent of the $7 trillion Treasury debt market — foreign central banks have asked the Treasury Department to increase the supply of the securities, and the department has acquiesced. Last year it issued roughly $58 billion in TIPS; this year about $85 billion, and the department has signaled that it could issue as much as $125 billion next year.
“So, the TIPS market is clearly growing,” says Pond. “Investors are realizing that zero is not the right answer as far as the right allocation for an inflation hedge within their portfolio.”
Another corner of the market enjoying robust investor interest is foreign exchange. John Normand, who steers J.P. Morgan’s London-based squad to the pole position in Currency/Foreign Exchange, says his analysts have been busier than usual as demand for research has surged. The reason? Sovereign-debt problems in Europe — and concerns that the contagion will spread — have prompted investors to question the creditworthiness of developed economies (see "September 2010 Country Credit: The New World Trumps the Old"). Concerns about national solvency and even questions about the viability of the euro have caused currency prices to fluctuate wildly, and many investors are eager to avail themselves of arbitrage opportunities (see "Is the Euro Zone Back From the Brink?").
“Because of the level of volatility, because of the pace of many of these currency moves, there’s certainly a much wider appreciation of how currency impacts overall investment returns,” says Normand.
The J.P. Morgan team was bullish on the Canadian dollar from January through July, telling clients that, thanks to low levels of consumer debt and high demand for housing, Canada would enjoy stronger real gross domestic product growth than the economies in Europe and the U.S., thereby allowing the Bank of Canada to raise interest rates before central banks in other Group of Seven nations. Right on both counts. Canada’s real GDP growth shot up 6.1 percent in the first quarter, compared with a meager 0.2 percent in the euro zone and 3 percent in the U.S. The Bank of Canada raised its benchmark lending rate by 25 basis points in June and a further 25 points in July, to 0.75 percent, while central banks in Europe and the U.S. opted to hold their rates steady.
“We entered 2010 long on the Canadian dollar and closed [the call] on July 30, once the U.S. earnings season ended, on a view that the market focus would turn to weak U.S. growth, in turn weakening the Canadian dollar,” Normand explains. “The trade netted 2.5 percent, which is decent for a currency pair that has been in a tight range this year.”
Foreign exchange strategies also afford investors the opportunity to express their views on the sovereign-credit issue, he adds. Optimistic investors are pouring money into commodities exporters and emerging markets, on the belief that the crisis will pass and the value of the related currencies will rise; those with a bearish view — that is, who believe the situation will worsen — have been investing in credit default swaps on the sovereigns, in effect betting that the issuing country will default on its debt, Normand explains. In light of the controversy surrounding CDSs and their use in the stock and bond markets, which many blame for not only amplifying the financial crisis in the U.S. but also triggering the sovereign-debt disaster in Greece, it’s perhaps not surprising that sophisticated investors have opted to access these instruments via forex.
“Given some of the regulatory issues that have come up around other markets, there’s been a preference by some clients to express their bearishness in the market which would be least restricted, and that’s foreign exchange,” says Normand.
Other analysts have also guided money managers through the controversial CDS market, including the J.P. Morgan team captained by Eric Beinstein and new co-leader Andrew Scott; the New York–based crew returns to first place in Credit Derivatives, the position it last held in 2008. (The sector was not published last year.) In January 2009 the analysts told investors to expect investment-grade bonds, which since the previous October had been priced less than the CDSs on the same entity, to outperform those instruments in the coming year. At the time, Beinstein says, the CDS-bond basis — that is, the difference between the CDS and bond spreads — was a negative 275 basis points. Their advice: Sell the swaps and buy the bonds.
“Over the next few months, this call worked very well — bonds outperformed CDSs by 140 basis points until June 8,” Beinstein says. “When the trade moved a little against us, we came out with an even stronger view that bonds would not only outperform CDSs, but would actually trade tighter than CDSs — that is, the basis would turn positive.” They were right: The CDS-bond basis first turned positive in early June 2010.
Like the CDS market, the Federal National Mortgage Association and Federal Home Loan Mortgage Corp. also were blamed for magnifying the financial crisis, but it’s time for investors to rethink their aversion to these government-sponsored enterprises, according to Margaret Kerins, who leads the RBS Securities squad to a fourth straight first-place finish in Federal Agency Debt Strategy. “New loans made in 2009 and 2010 are cleaner, due to the tightening in credit standards and higher loan-to-value ratios,” the Chicago-based strategist explains. “Loans from the problem books that have not already defaulted should be all right, as they have made it through the recession — as long as the economy is turning around.”
If the U.S. economy falls back into recession, the federal government would likely step up its support of the mortgage backers, Kerins believes. “Investors should not shy away from agency debt over fears regarding future government support,” she says. “The Treasury Department is providing an unlimited backstop to Fannie Mae and Freddie Mac until the end of 2012, at which time the support reverts back to $274 billion [a year]. Therefore, investment decisions in agency debt should be made on a relative-value basis, which currently favors U.S. agencies over Treasuries and supranational, sovereign and non–U.S. agency debt.”
Whether round two of the recession is imminent is a question on many investors’ minds, but fixed-income analysts and directors of research are cautiously optimistic.
“We’re not in the double-dip camp,” declares Deutsche’s Hooper. “But our view has been that the recovery was going to be depressed relative to anything that we’ve seen historically — so it’s a bit of a mixed view overall.”
J.P. Morgan’s Belton is more upbeat. “We’re quite positive in our year-end outlook in terms of fixed-income spread markets,” he says. “You have interest rates staying low for a long period of time. Growth is not strong enough to cause interest rates to rise, but it’s not weak enough to really cause default risks to rise in any meaningful way. We see most credit markets doing well in the second half of the year.”
No doubt many investors hope he is right, and will rely on the members of the 2010 All-America Fixed-Income Research Team to direct them to the best opportunities as the market recovers.
