In today’s volatile bond markets, investors demand instant analysis plus hand-holding, as well as hot tips. Result: a new approach to bond research , one our team members excel at.
By Sara Kandler
August 2001
Institutional Investor Magazine
J.P. Morgan’s William Cunningham was several minutes into his presentation on the corporate bond outlook early this January when a colleague interrupted him. “The Fed just eased 50 basis points!” she shouted. For a moment the 250 investors and analysts in the audience at New York’s Metropolitan Club mulled the news, then they began to applaud: The Federal Reserve Board,s unexpected and unexpectedly large interest rate cut would no doubt boost bonds.
But how big would the rally be? And how far was the Fed prepared to go to jump-start the slowing economy? All eyes turned to Cunningham, Morgan,s investment-grade bond strategist, who was stranded at the podium with suddenly obsolete notes and charts. “It created a real quandary for me,” recalls Cunningham. “I had to address the question, Where does that leave us in six months?”
Cunningham’s awkward moment , he pulled it off with aplomb by hastily adjusting his predictions , underscores how much investors have come to expect instant analysis of the fixed-income markets, every gyration. “Corporate bonds are much more volatile than before, so much so that some of them resemble equities,” says Ivor Schucking, an investment-grade corporate bond analyst for Pacific Investment Management Co., manager of $220 billion in fixed-income assets.
Indeed, the best bond analysts today operate much like stock analysts. They communicate constantly, providing reams of data electronically; probe deeply into market niches; work closely with nervous clients; and look to add value with timely trading tips. Fast becoming an anachronism in this up-tempo world is the cerebral 50-page research report.
“We try not to do big think pieces,” says Robert Waldman, Salomon Smith Barney’s global head of corporate bond research.
In the midst of California’s energy crisis, the firm’s utilities bond analysts John Melesius and Deborah Grosser were distributing intraday updates on volatile bonds like those of Pacific Gas and Electric Co. to their sales and trading colleagues for them to pass on to clients. “We were trying to keep the market continuously apprised of developments,” says Grosser. “Fluctuations in bond trading levels on any given day were dramatic.”
Along with the obsession with speed has come fierce competition. “What we,re seeing is a capital markets version of the Weakest Link,” says Credit Suisse First Boston U.S. high-grade credit research chief Allerton (Tony) Smith, referring to the rough-and-tumble TV game show. “It’s a bare-knuckles battle to be right and keep investors in the bonds that will make them money and keep them out of trouble.” The U.S. bond market overall had a terrific year in 2000. Its total return of 11.6 percent, powered by Treasuries, 13.5 percent return, beat the stock market for the first time in a decade. But many sectors fared poorly. High-yield bonds on average lost 5.8 percent of their value. Although that was better than the Standard & Poor’s 500 index,s 10 percent loss, this was small consolation to investors who,d dumped plain-vanilla Treasuries to reach for extra yield.
Inflation worries, lousy telecommunications earnings and an inverted yield curve all made sector selections in general tricky , putting a premium on credit research. Investment-grade corporates underperformed Treasuries by their largest margin , 413 basis points , since the 1981,,82 recession. Notes Merrill Lynch bond strategist Thomas Sowanick, “The reality that credit quality can deteriorate as the economy continues to expand caught a lot of investors off-guard.” Only partially in jest, Jack Malvey, Sowanick’s counterpart at Lehman Brothers, adds, “2000 was one of the worst good years we,ve ever had.”
The penalty for mistakes in today’s turbulent markets is huge. “Managers, returns are volatile because the dispersion of outcomes is enormous,” says CSFB bond strategist David Goldman. Consider this: In December 1996 the average spread among triple-B-rated seven- to ten-year bonds was 72 basis points, and 70 percent of similarly rated bonds could be found in the 60-to-80-basis-point range; in December 2000, however, the average spread among bonds in this same sector was 235 basis points, and a spread range of 150 to 250 basis points was needed to capture 70 percent of that universe.
Conditions this year are even tougher than in 2000. Bond returns, though still outdistancing those of stocks, haven,t kept up with last year,s. In the first half of the year, fixed-income securities in aggregate returned 3.6 percent. As the U.S. economy has weakened, companies, credit troubles have mounted. The ratio of downgrades to upgrades in 2001’s first six months was 3.1-to-1, the highest ratio since 1991, according to Moody’s Investors Service. Last year it was 2.3-to-1. And the corporate default rate of 8.15 percent is also near a ten-year high, led by a slew of overextended telecoms. Moody’s expects the rate to climb to 10 percent by early 2002 before falling.
Nevertheless, certain firms have been able to consistently find value for bond investors, even under these challenging circumstances, and our tenth annual All-America Fixed-Income Research Team reflects their success. Lehman Brothers takes first place for the second consecutive year, with 35 team positions. But its margin of victory has narrowed to a single place, compared with seven positions last year. Merrill Lynch repeats at No. 2, with 34 positions.
Both firms have been consistent survey leaders. In the ten years that Institutional Investor has published separate U.S. fixed-income rankings, only three brokerage houses have claimed top honors: Lehman (six times), Merrill (four times) and Bear, Stearns & Co. (once). Lehman and Merrill once tied for the top spot.
Major shifts in the next tier of rankings are traceable to Wall Street megamergers. Credit Suisse First Boston is the biggest gainer, leaping into third with 32 team positions. Last year it was ninth with ten team positions. CSFB, of course, acquired high-yield powerhouse Donaldson, Lufkin & Jenrette, which ranked No. 6 in 2000. “The merger with DLJ provided us with a turnkey solution to getting to our expansion goal much more quickly,” says CSFB’s Smith. CSFB nudges Salomon Smith Barney down one rung to fourth, with 27 positions. The new J.P. Morgan takes the No. 5 spot (with 23 positions), buoyed by its merger with Chase Manhattan Bank. (Last year Chase Securities ranked fifth, while Morgan came in at No. 11.)
Many fixed-income research groups have been bulking up, despite brutal market conditions for firms generally. Moreover, healthy bond issuance and relatively strong bond market performance have left most fixed-income research departments relatively unscathed by layoffs.
Lehman’s high-yield team has added 15 senior and junior analysts in the U.S. and Europe since January 2000, in an effort to halve the number of industry sectors each researcher covers, to one or two from three or four. Goldman, Sachs & Co. and Morgan, among others, have also been adding junior analysts, to concentrate coverage. Goldman’s director of high-yield research, Roger Gordon, who has hired 12 junior analysts in New York and London since January 2000, likens his firm’s new fixed-income research model to that favored by his equity counterparts. “We now have at least pairs of people following industry sectors,” he says. The theory is that hiring more junior analysts to do the scut work and reducing the scope of coverage should free up senior bond analysts to render the rapid judgments that clients now demand.
Not all clients are applauding these developments. Buy-siders complain that fewer Wall Street firms cover the gamut of fixed-income securities and that analysis of typically less-profitable areas , such as Treasuries and agencies , has dwindled. “Last year there was a tremendous decrease in the amount of research available,” says Michael Hoeh, senior portfolio manager for Dreyfus Corp. “There was less competition among dealers to put out innovative research.”
The steady growth of the U.S. fixed-income business has attracted European firms, including Barclays Capital, Deutsche Bank (through its U.S. investment banking subsidiary Deutsche Banc Alex. Brown) and UBS Warburg. Barclays has been one of the most aggressive. Though the British bank failed to lure away a team of 40 fixed-income professionals from CSFB earlier this year, it did hire derivatives strategist Brad Stone from Goldman to head its U.S. bond market strategy and energy analyst Mark Pibl from Merrill Lynch to direct its investment-grade bond research. Barclays plans to hire another four to six fixed-income analysts in the U.S. by year-end and another four to six early next year.
Deutsche Banc, seeking to position itself as a leader in structured finance, recruited Goldman Sachs veteran Anthony Thompson in December to cover collateralized debt obligations. Thompson joins Karen Weaver, formerly CSFB’s head of securitization research, who joined Deutsche in April 2000. The bank also picked up sovereign bond analyst José Luis Daza, who left Morgan following its merger with Chase. UBS Warburg, as part of its drive to expand, landed mortgage-backed guru Laurie Goodman (who ranks in five II categories this year) through its PaineWebber purchase and recruited former high-yield research chief Steven Ruggiero from Morgan to serve as its global head of high-yield research. It’s too early to tell what kind of impact Barclays, buildup will have (this year the firm didn,t field a single team member). But efforts by Deutsche Banc and UBS are paying off: Deutsche Banc rose three notches this year, to No. 9; UBS Warburg climbed two places, to No. 8.
In a case of turnabout is fair play, U.S. bond players are going abroad to exploit what they see as a promising market in borrowing by U.K. and continental European companies. International bond issuance has exploded, almost doubling in the past three years, to E1.3 trillion ($1.2 trillion) in 2000 (and E894 billion through this year’s first half), according to Morgan.
Research is critical to this foreign push. Lehman, for instance, has hired 20 analysts across its fixed-income research group in Europe, and Morgan has more than doubled its European research team, to 19 analysts, over the 12 months through June. “Last year was a turning point in terms of European and U.S. rates becoming very similar,” says Ravi Mattu, Lehman’s head of global fixed-income research. “It is looking like a single capital market.” Fixed-income analysts will increasingly have to reckon with the one-world phenomenon in the future.
