Startingover

Superbanks were gaining ground just as the world changed on September 11. Will their strategies still work in a much riskier environment?

Superbanks were gaining ground just as the world changed on September 11. Will their strategies still work in a much riskier environment?

By Deepak Gopinath
November 2001
Institutional Investor Magazine

For the complete Fixed-Income Trading Ranking results, please go to the Research & Rankings section of this site.

The bond market closed on the morning of September 11 in chaos. Many trading screens went blank, Treasury yields were plummeting, and in all the confusion no one was quite sure if transactions that occurred that day were even valid. Bonds resumed trading two days later, but that was about the only similarity to the market that previously existed.

“The markets just didn’t want to do business because so many bond professionals had personal connections to people affected by the tragedy, and other people couldn’t do business because of the logistical problems they experienced,” says Bart McDade, co-head of fixed income at Lehman Brothers. He has firsthand knowledge. Located in the World Financial Center across the street from the obliterated World Trade Center, McDade and his group had just two hours to try to clear out as much of their trading infrastructure as they could and move it to makeshift quarters across the Hudson River in Jersey City, New Jersey.

Traders at Lehman and their colleagues at other firms first had to confront the personal loss. More than 700 employees of Cantor Fitzgerald, the broker’s broker that virtually every firm dealt with, were presumed dead along with many other traders, salesmen, bankers and analysts at firms like Sandler O’Neill & Partners and Euro Brokers. “We have lost a lot of experience,” says John Atkins, fixed-income analyst at IDEAglobal, an independent research firm. “Everyone knew people at Cantor; you couldn’t do business without it.”

The market also had to overcome some basic operational shortcomings. Lehman and Merrill Lynch & Co., among others, were hard-pressed to function at anything near capacity in the first days after the reopening, and liquidity was tight. With many firms scrambling to fix ruined computer and communications systems and key intermediaries such as Bank of New York unable to operate effectively, the number of failed trades rose dramatically in the days after the destruction. The Federal Reserve Board, in two easings, cut rates by 100 basis points, and in early October the Treasury held its first-ever unscheduled ten-year note auction to create some additional liquidity.

Within days, however, the market began to regroup. Interdealer trading platforms, such as BrokerTec and Cantor’s eSpeed, were functional when the market reopened. And TradeWeb, a dealer-to-customer platform, was back up in early October. As most of the displaced firms resettled, some sense of normalcy returned. “It was very impressive how smoothly the markets handled the dislocation caused by the events of September 11,” says Thomas Maheras, global fixed-income head at Salomon Smith Barney. “Virtually every product in the fixed-income universe was up and trading that same week, and after widening out quite a bit initially, quotes had tightened nicely by the time the markets reopened.”

Still, there are fundamental questions that remain to be answered. “The outcome for the market depends on the U.S. military response to the attacks and the duration of that response. If the response is quick and short, the market will view it positively,” says Walid Chammah, Morgan Stanley’s global head of fixed-income capital markets. “Unfortunately, this is an unlikely outcome, and the market has to learn to operate in an environment with more uncertainty. That means the buoyant mood that we had in the fixed-

income market in the early part of the year might not return for some time.”

Even in the first few shaky days of operation, the market reassessed risk. Spreads between higher-grade corporates and Treasuries widened 43 basis points, and six-month Treasury rates fell by about 50 basis points, to 2.25 percent, as investors sought a liquid haven. Long-term Treasury rates remained virtually unchanged until October 31, when the Treasury unexpectedly announced that it would no longer sell 30-year bonds, causing rates to tumble and prompting widespread losses. The market lost another key benchmark and hedging device. The government had been selling bonds of that maturity for 25 years. In the credit-sensitive high-yield market, bonds lost nearly 5 percent of their value in the two weeks after the September 11 tragedy as spreads widened by nearly 180 basis points, to about 960 basis points.

There were shifts in the long-term economic outlook as well. Renewed federal deficits, heavier Treasury borrowing and a contraction in GDP moved up the list of probable scenarios. Initial worries that long-term rates would rise, choking off private sector investment, prompted Federal Reserve chairman Alan Greenspan to counsel Congress to moderate the size of its emergency fiscal stimulus package. Economic weakness is expected to last a bit longer and cut a little deeper than previously forecast. An economic contraction is expected in the third and fourth quarters of this year, followed by 1.4 percent and 2.9 percent growth in the first and second quarters of 2002, respectively, according to the consensus estimate of 51 economists participating in an October survey by newsletter “Blue Chip Economic Indicators.” According to the survey, the economy is expected to grow an anemic 1.5 percent next year. In contrast, the pre-September 11 consensus had predicted accelerating growth in the third and fourth quarters of this year, with the economy growing 2.7 percent in 2002.

“Investors have to be resigned to an ugly finish to 2001,” says Moody’s Investors Service chief economist John Lonski. “The only silver lining may be that corporate creditworthiness may benefit in late 2002 from an enlivening of economic activity because of the application of huge amounts of monetary and fiscal stimulus.”

That’s a far cry from the outlook in early September, when the fixed-income markets were looking to put the wraps on a relatively strong year. More than $1.4 trillion of new debt hit the market in the first eight months of 2001, topping 2000’s full-year total; long Treasuries had returned 4.96 percent, against a 14.1 percent decline in the Standard & Poor’s 500 index, and fixed-income sales and trading revenues at firms like Goldman, Sachs & Co., Bear, Stearns & Co. and Lehman Brothers were rising sharply toward record levels, offsetting some of the weakness in investment banking and equity trading. Even high yield, the worst-performing fixed-income sector for the previous two years, was up 5.89 percent through August. “Prior to the crisis, the slowing economy combined with Fed easing made for an attractive fixed-income environment,” says David Solomon, co-head of the credit businesses at Goldman Sachs.

This new, riskier environment is expected to accelerate the dominance of the biggest bond dealers, especially the recently minted giant commercial-

investment bank combinations that can weather a tough period best. “There is a clear shift in volume and market share toward the superbank platform,” says John Steinhardt, co-head of North America credit markets at one of the new breed, J.P. Morgan. “It is a sea change in the business. We have a better structure and are going to pick up market share as a group.” Pure-play investment banks are eyeing this trend warily. “In fixed income, commercial banks have an advantage over the pure-play investment banks because of their ability to lever their credit extension capabilities into higher-margin underwriting business,” says Morgan Stanley’s Chammah. Adds Solomon: “There’s no question that lending and credit extension have had an impact on the high-grade corporate bond business and on market share. But it is unclear how that will evolve over a longer period of time.”

This surge in activity was evident well before September 11. Although the signs are hardly definitive, the results of Institutional Investor’s seventh annual fixed-income trading poll show that the commercial-investment bank combines are making strides. Salomon Smith Barney, whose trading activities include those of Citibank, took first place overall for the third year in a row. J.P. Morgan’s acquisition by Chase Manhattan Corp. last year catapulted the firm three notches to sixth place, and UBS Warburg jumped two positions to eighth, thanks to its purchase of PaineWebber. Credit Suisse First Boston’s absorption of high-yield powerhouse Donaldson, Lufkin & Jenrette allowed it to snatch the top place in high-yield corporate bonds (although its overall ranking didn’t change).

Several major investment banks lost ground: Merrill Lynch fell from second to third place, Goldman Sachs dropped a notch to fourth (votes were counted separately for Goldman’s subsidiary, Spear, Leeds & Kellogg, which finishes 13th), and Bear Stearns tumbled three spots to ninth. Morgan Stanley held on to fifth place. Only Lehman gained, jumping two places to second overall, because of its strength in specific areas like real estate, asset-backed securities and mortgages that prospered during 2001.

To some market participants at least, the superbanks’ ability to win underwriting assignments is key to improving their standing in the world of trading. “Anytime you control new issues, you have the advantage in secondary trading,” argues David Goldman, head of fixed-income strategy at Credit Suisse First Boston. Adds J.P. Morgan’s Steinhardt: “Given [the superbanks’] larger new-issue market share, they have more market information to use and share with the client base. They have more capital to use in the business when they need it, and given the larger revenue base they have from larger market share, they can afford more salespeople, analysts, et cetera, to support the whole franchise.”

Still, it’s hardly a certainty that the financial world’s latest strategic initiative will prevail. “It is company-specific,” says UBS Warburg bank analyst Diane Glossman. “The fact that a Salomon, for example, has more capital than a Lehman doesn’t mean it is putting more of it to work in fixed income.” Salomon has benefited from astute cross-selling of products to Citigroup and Salomon customers rather than from a huge commitment of capital to a single area like fixed income. Other banks may not be as successful at it, says Glossman. And the superbanks may find their lending exposure to deeply troubled parts of the economy, such as travel, coming back to haunt them.

Whoever moves ahead will do so in a much more difficult environment. Although through October 1 the Merrill corporate master index returned 10.02 percent year-to-date versus the S&P 500’s more than 20 percent decline and the Nasdaq composite index’s 40 percent fall, that outperformance may not continue. After all, interest rates can fall only so far. “Fixed income’s potential outperformance is limited by coupons - with ten-year Treasuries below 4.5 percent, there is little upside. Any kick-up in equity will blow fixed income away,” says CSFB’s Goldman. By mid-October the stock market had already recouped its post-September 11 losses, while bonds made little headway. But stock market gains may not be sustainable. “The stock market is usually an early indicator of a turnaround, but my personal view is that may not be the case this time around,” says J.P. Morgan’s Steinhardt. “The recession may be longer and deeper than the stock market is implying at this point.”

Leading firms that depend heavily on high yield will find the post-September 11 environment particularly tough. High-yield spreads in late September were the highest they’ve been since the last recession, in 1990-'91. “We will see credit quality weakening more; we’ve had 14 consecutive quarters of net downgrades, and rating agencies have

increased default forecasts,” says IDEAglobal’s Atkins, who believes higher-rated corporates will remain defensive plays nonetheless. In an outlook updated after September 11, Moody’s says it expects high-yield default rates to hit 11 percent next year, up from its 10 percent forecast earlier (though still less than the 13.1 percent level in 1991). High-yield issuance, which had already been limited to top-tier borrowers, effectively dried up, and liquidity in the high-yield market has yet to recover.

As always, radical changes provide opportunities for traders. Lower rates will eventually coax higher-quality corporations to borrow. “The single largest driver of issuance is absolute coupon,” says CSFB’s Goldman. “It has been a long time since you’ve been able to raise ten-year money at 5 percent. Issuance [for higher-rated borrowers] has gotten back to a very healthy level very quickly indeed.” In the weeks following the attacks, for example, Bristol-Myers Squibb Co., rated AAA by Standard & Poor’s, successfully placed a $5 billion issue (it was increased from $4 billion) yielding 4.81 percent for a five-year $2.5 billion tranche and a ten-year tranche yielding 5.8 percent. Conoco, rated BBB+ by S&P, followed with a $4.5 billion deal (increased from $2.5 billion) at yields ranging from 5.48 percent for five-year bonds to 6.37 percent for ten-year bonds and 7.35 percent for a 30-year tranche.

And credit enhancement available in the derivatives market may well thrive. “More and more, users of capital are going to use credit default swaps to hedge credit risks,” says Morgan Stanley’s Chammah. Says Salomon’s Maheras, “Derivatives and structured solutions are still going to be very much in demand.” The limiting factor? Counterparties to the risk may be hard to find or willing to participate only at exorbitant prices.

Analysts don’t expect next year’s fixed-income returns to match this year’s, though there may be some upside in specific sectors. Investment-grade corporates are expected to benefit from a flight to quality and a decline in underlying interest rates. Mortgages are likely to benefit from the lower-interest-rate environment. And high yield could be set for a rebound if the economy recovers early next year. “Lower-quality corporates will be a top-performing sector,” says Jack Malvey, chief global fixed-income strategist at Lehman, who notes that U.S. high yield returned 46 percent in 1991, as the economy emerged from recession.

And technology, much of which functioned throughout the crisis, is likely to become only more important. However, the proliferation of competing electronic bond trading platforms is over, and now the number of viable alternatives is likely to start to plummet. At the end of last year, TowerGroup, a Needham, Massachusetts-based research firm specializing in technology use within the financial services industry, estimated that there were 106 trading platforms, a number that has already dropped to about 90. The figure is expected to come down sharply from there. “The inability to attract users, liquidity and revenue was the most common problem,” says Anders Nybo, technology analyst at TowerGroup, who forecasts that the number of platforms will drop to 12 by 2005. “If they don’t have liquidity, they are not offering their customers anything.”

Associate Editor Emily Fleckner compiled the statistics for this feature under the direction of Senior Editor Jane B. Kenney.

For the complete Fixed-Income Trading Ranking results, please go to the Research & Rankings section of this site.

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