Click here to view the entire 2003 All-America Fixed-Income Research Team results available in the Research & Rankings section of this site.
For William Gross, this summer’s sharp backup in rates was more than a momentary correction. It marked the end of a golden era.
“It’s the negative of the positive that we’ve seen for the past 20 years,” says Gross, chief investment officer of Newport Beach, California-based Pimco and arguably the most successful bond investor of his generation.
Gross, whose firm manages $349 billion, explains, “When the economy was disinflating from the double-digit inflation rates of the late 1970s and interest rates were coming down, that was the best time to buy bonds.” Now he sees the U.S. economy heading into a “period of mild reflation” that could push rates higher. Skittish fixed-income investors and analysts will be watching for hints of inflation, owing to “the larger federal deficit we’re going to see for the next several years,” says Gross.
On June 25 investors got their first sign that the 20-year bull bond market was coming to an end: The Federal Reserve Board cut the federal funds rate by 25 basis points to 1 percent -- instead of the half-point ease that many market participants had expected. The subsequent selling by investors, exacerbated by mortgage players rebalancing their hedges, drove the benchmark ten-year Treasury yield from a 45-year low of 3.07 percent in June to 4.51 percent by mid-August. After pumping a record $213 billion into bond funds from January 2002 through June 2003, investors withdrew $3.6 billion in just one week in early August -- the biggest weekly net outflow since 1994’s devastating bond market rout.
The midsummer debacle ended a spectacular run. Bonds easily bested stocks for the third straight year, the first time that had happened since the Great Depression. Last year Lehman Brothers’ broadest bond index returned nearly 10 percent. It had gained almost 5 percent more this year before the Fed brought the market up short. The central bank took pains at its August meeting to assure the markets that it was not planning to raise rates anytime soon, but by then most of the damage was done: Bonds lost 4.4 percent between June 13 -- the low point for the ten-year bond’s yield -- and mid-August.
With bountiful fixed-income returns a thing of the past, securities dealers must face the prospect that their money-spinning fixed-income businesses -- which had helped make up for equity and investment banking revenue that disappeared after the stock bubble burst in 2000 -- will also wilt. That means that sell-side fixed-income analysts, bruised from battling corporate credit woes, will have to “adjust to a new rate environment,” says Michael Guarnieri, global credit research head at Lehman Brothers, which takes the top spot on Institutional Investor‘s All-America Fixed-Income Research Team for the fourth year running. In changeable markets investors remained constant in their opinion of which firms are providing the best research. They award Lehman 35 team positions, unchanged from its 2002 showing. No. 2 Credit Suisse First Boston follows, with 33 team positions, and J.P. Morgan takes third, with 30 slots. Last year CSFB and J.P. Morgan shared second place, with 31 team positions each.
Underscoring the market’s volatility was last year’s snapback in credit spreads, which had ballooned following America’s embarrassing string of bankruptcies and accounting scandals in late 2001 through mid-2002. Spreads on high-yield corporates, as measured by Standard & Poor’s, widened by a whopping 343 basis points to a high of more than 10 percentage points over Treasuries from January through October 2002. At those levels “high-yield credits were too cheap to resist,” says James Sullivan, who oversees $147 billion in fixed-income investments at Prudential Fixed Income, based in Newark, New Jersey. That led retail investors to plow $21.6 billion into high-yield funds in the first half of 2003, almost double what they invested in all of last year, according to Arcata, California-based funds tracker AMG Data Services.
The cash infusion helped. In no time, Sullivan says, the high-yield sector was “technically looking very sound, because so much money was pouring into it.” That money allowed low-rated companies to refinance or extend their debt. Performance numbers show how quickly the turn came. High-yield corporate bonds posted an 8.6 percent loss in 2002 through the mid-October high in junk credit spreads; since then they’ve gained a staggering 24.2 percent through mid-August, according to Lehman’s indexes.
Even after the turn in the Treasury market, junk bonds held their own, losing 2.5 percent from mid-June through mid-August, compared with a loss of 6.3 percent for investment-grade securities. Stronger economic growth could lead investors to place less emphasis on companies refinancing themselves at lower rates and pay more attention to buyout or expansion financings seeking to take advantage of renewed growth, says Lehman’s Guarnieri.
Investors, of course, appreciated anyone who urged them to seize the high-yield opportunity. Lehman retailing analyst Susan Jansen jumps two spots to first in large part because of her January 2003 buy on drug chain Rite Aid Corp. Although it had recently been considered distressed, Rite Aid boasted annual cash flow growing at a 40 percent compounded clip, and its “financing outlook had brightened meaningfully,” says Jansen. Through mid-August total returns on Rite Aid’s bonds ranged from 24 percent to 32 percent.
To cope with changing debt markets, researchers have reached for new tools. Increasingly, investors and brokerage firms alike are adopting options-based default-prediction models such as that provided by Moody’s KMV Co., an independent, San Francisco-based firm owned by the credit rating agency. Models like Moody’s KMV’s use the volatility of the value of a business’s assets, among other variables, to predict the likelihood that the company will exercise its option to default.
To be sure, institutional investors have gripes, many relating to the scandals that have tarnished equity research. Bond analysts “are so afraid of getting into trouble, they don’t want to say anything,” sighs one investor. Still, buy-siders grudgingly approve brokerage firms’ research efforts over the past year. In our 2003 fixed-income survey, 19 percent of those answering the question said they were “very satisfied” with the quality of sell-side fixed-income research, up from 16 percent in 2002; 26 percent thought research had improved over the previous year, compared with 21 percent in 2002.
Turnover among senior analysts -- mostly because of layoffs and the lure of employment at hedge funds -- is causing some buy-siders to complain about less bench strength. “No matter how smart they are, they can’t replace someone who’s been through the entire credit cycle at least once,” says one unhappy investor. “I like a few gray hairs.”
If Bill Gross is right, he’s likely to see a lot more of them on Wall Street.
The rankings were compiled by Institutional Investor under the direction of Senior Editor Jane B. Kenney, Assistant Managing Editor for Research Lewis Knox and Associate Editor Emily Fleckner. Contributing Editor Ben Mattlin wrote this overview. Click here to view the entire 2003 All-America Fixed-Income Research Team results available in the Research & Rankings section of this site.
