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The 2004 All-America Fixed-Income Research Team
Bond departments may be preoccupied with looming regulatory challenges, yet these analysts still did first-class work.
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As stocks go, so go bonds. That's hardly a reliable investing principle, but when it comes to predicting patterns in securities research, the rule appears to apply with uncanny accuracy.
Thus in April 2003, when ten of the nation's most prominent securities firms agreed to pay $1.4 billion to settle regulators' charges of conflicts of interest involving their
equity research, it seemed a good bet that those regulators would soon turn their attention to potential conflicts in fixed-income research.
Moving to head off any unwelcome edicts, the Bond Market Association, the industry's trade group, published this May a 75-page tome, "Guiding Principles to Promote the Integrity of Fixed Income Research," that identifies potential conflicts in bond research departments and suggests ways to avoid them. On the BMA's forbidden list, a raft of prescriptions familiar to stock researchers: using analysts to solicit or market investment banking services, allowing bankers to evaluate or compensate analysts and permitting traders or bankers to influence the content or timing of research.
Whether or not the BMA guidelines stave off regulatory action remains to be seen. In June, Douglas Shulman, president of the National Association of Securities Dealers' services and information group, told the Senate Banking Committee that the regulatory agency is considering codifying the BMA's guidelines in formal rules. Moreover, the Securities and Exchange Commission, embarrassed by New York State Attorney General Eliot Spitzer's aggressive moves on equities, is not sitting still.
"Whether additional regulatory action will be necessary to address research analyst conflicts in the fixed-income markets has not been determined," reports Annette Nazareth, director of the SEC's division of market regulation. "The commission is actively engaged in discussions with a number of multiservice firms concerning their self-assessments of conflicts of interest."
One thing is clear in all this: Fixed-income research is under scrutiny as never before.
And not just by regulators. In an unsettled investing environment, nothing is more important to investors than thoroughgoing securities analysis and a relationship of trust with their brokers.
In investors' eyes no brokerage firm surpasses Lehman Brothers in delivering topflight fixed-income research. The firm ranks No. 1 in Institutional Investor's 13th annual All-America Fixed-Income Research Team, marking its fifth consecutive year in the top spot. (Lehman is also the reigning No. 1 team for equity research.) Adding four team members to last year's 35, Lehman edges out a rising J.P. Morgan that places seven additional analysts on the team this year, bringing its total to 37 and lifting it a spot from third place. Falling one notch to No. 3 is Credit Suisse First Boston, with 31 positions. Holding onto fourth and fifth are Citigroup and UBS, with 22 and 21 positions, respectively.
In other notable moves: Merrill Lynch jumps from tenth to a tie for seventh with Deutsche Bank; Morgan Stanley drops three rungs to ninth; and Goldman, Sachs & Co. falls two places to 11th.
Even before the BMA issued its May report, bond research directors began to overhaul their organizations and revise their policies and procedures. At J.P. Morgan analysts no longer accompany bankers on client pitches or host roadshows. New fixed-income research hits the trading desk and clients "concurrently and simultaneously," says Margaret Cannella, head of the bank's North American credit research. Earlier this year about 40 of the bank's credit analysts at 270 Park Avenue in New York City moved several floors away from J.P. Morgan's trading desk to avoid even the hint of conflict.
The BMA guidelines "clarified the interaction that research can have with banking," notes Dale Westhoff, head of research in the rates and structured-products sectors at Bear Stearns. Westhoff is also leader of the No. 1 team in MBS/Prepayments and co-leader with Bruce Kramer of the No. 1 team in MBS/Nonagency-Structured Products. "We now have a very limited relationship with investment banking that does not involve any marketing-related activities," Westhoff says.
The idea of segregating bankers and analysts, says Banc of America Securities' global head of debt research, David Goldman, is "to ensure that improper communication not only shouldn't occur but can't occur." The bank has moved a few analysts with trading-related functions, such as risk-modeling, out of research altogether and into the trading department. What's more, BofA's Goldman now reports to the firm's chief operating officer rather than to its fixed-income head to emphasize that he and his 100 analysts operate free and clear of BofA's debt-underwriting and trading businesses. BofA also supervises all communications between researchers and investment bankers. Analysts, for instance, can present views derived from public sources to investment bankers, but the bankers can't respond to the analysts.
Are such changes really needed in an institutional marketplace? Most big investors consider themselves to be sophisticated money managers who have built up sizable research departments. They also have a fiduciary duty to make their own investment decisions.
Indeed, fewer than 20 percent of the representatives of the more than 240 major institutional firms responding to the question thought the guidelines would improve the quality of research. More than 23 percent felt they wouldn't, and more than 57 percent said they didn't know if the guidelines would have an impact at all.
"We just assume there are some biases" on Wall Street and take that into account, says Kurt Kreienbrink, a telecommunications analyst at Thrivent Financial for Lutherans, which oversees $40 billion in fixed-income assets. Ultimately, he says, Thrivent's 29 analysts are responsible for their own investment recommendations. Charles Wyman, head of global credit research at Pacific Investment Management Co., points out that what Wall Street analysts don't always realize is that "we care much less about what they think than why they think it."
"We don't need a 50-page independent report on an industry, since we already have analysts looking at different sectors," adds Kevin Akioka, a high-yield portfolio manager at Payden & Rygel, which handles $51 billion in bonds. "The added value of the sell side is that they know what's going on with market flows and trading color."
That's especially true when markets defy the consensus. At the end of June, the U.S. Federal Reserve Board made its long-anticipated move to raise interest rates, hiking the overnight rate by 25 basis points, to 1.25 percent. Most investors had foreseen generally poor returns for fixed-income securities in the wake of a Fed hike. But then economic growth slowed, interest rates fell, and bonds proved a surprisingly good bet.
Because this year's issuance is down dramatically from last year's, demand for corporate bonds has remained strong. "Investors want to know which sectors have juicy spreads, whether those spreads are justified and how they can get exposure to those yield levels without taking on undue risk," says Marc Pinto, head of credit research in the Americas for Merrill Lynch.
Both investors and researchers note a significant improvement in credit quality during the past year. In 2003, Moody's Investors Service recorded 458 downgrades of U.S. corporate debt and 199 upgrades. In this year's second quarter, however, Moody's registered 78 upgrades and 77 downgrades -- marking the first time in six years that upgrades exceeded downgrades.
Back in 2001 and 2002, investment-grade companies, hit by a weaker economy, were crossing over into junk; last year many of them began stepping back up to investment grade. "The credit story for investment-grade bonds no longer has any real play," says Thomas Letteri, senior research analyst in fixed income at Mellon Capital Management Corp.'s private wealth management group, which oversees $15 billion in investment-grade bonds. "High-yield and crossovers into investment grade are where dealers can make hay."
Consider J.C. Penney Co. First-team investment-grade retailing researcher Cannella of J.P. Morgan made a prescient call last October after the retailer, whose debt had been relegated to junk status in 2001, announced plans to sell its Eckerd Drug Store chain. The likelihood that J.C. Penney would use the proceeds to pay down debt convinced her to put a buy on the bonds. By the end of July this year, J.C. Penney's 2010 bonds had narrowed from a 150-basis-point spread to 85 basis points.
Wall Street firms have adapted to changing market conditions by focusing on individual companies' capital structures as well as trying to identify which fixed-income sectors will outperform. For example, Lehman's Scott Shiffman, who ranks No. 1 in both Investment-Grade Media & Entertainment and Investment-Grade Telecommunications Services, made an astute early call on Verizon Communications, the largest telecom issuer in Lehman's benchmark investment-grade index. Since the first quarter of 2003, Shiffman has argued that Verizon's $12 billion in operating-company debt would ultimately underperform relative to its holding-company paper. That prediction proved correct in the second quarter of this year.
Capital structure arbitrage is a favored strategy of many hedge fund managers. Earlier this year, Lehman introduced research in capital-structure arbitrage strategy and moved a number of analysts into this area. "We've geared our research to be more idea-focused to target hedge funds," says Michael Guarnieri, global head of credit research.
He adds that demand for credit-default-related research, which assesses the relative costliness of a particular issuer's credit derivatives, grew "by multiples" last year. "Any credit analyst here who covers a sector does default swaps as well as cash bonds," Guarnieri says. The overlap enables researchers to better understand where value may lie in a credit's capital structure.
Many research teams have also aggressively added credit strategists or quantitative groups focusing on credit derivatives. Merrill's Pinto notes that his current 40-person credit group doubled in size over the past two years and will increase further. BofA Securities two years ago launched a quantitative credit strategy group whose analysis relies extensively on proprietary credit risk and portfolio analysis models; the group now includes 15 analysts.
The focus on credit risk offers investors trading ideas as well as portfolio diversification, says BofA's Goldman. Unlike bottom-up credit analysis, credit valuation systems can assess whether, say, the "risks in an automotive bond differ from the risks in an oil services bond or a financial company bond," he notes. "This can help investors determine whether they have the right level of diversification."
At the same time, researchers are helping investors understand connections among previously separate asset classes. Bear Stearns' Westhoff notes that record levels of activity in the mortgage market, "the 800-pound gorilla of fixed income," have increasingly produced linkages among Treasuries, agencies, interest rate derivatives and the credit markets. That's because banks and other mortgage originators hedge their massive portfolios in various markets. As a result, investors want to know how shifts in mortgage activity will play out across sectors.
While research in credit derivatives and mortgage-backed securities continues to expand, municipal bond coverage is dwindling. Although municipalities are issuing a record number of bonds, small issues dominate, and there is often insufficient secondary trading to justify sell-side research. A number of large dealers are also committing less capital to holding municipal bonds in their inventories, notes Robert Millikan, director of fixed income and a portfolio manager at BB&T Asset Management, which oversees $5 billion in fixed-income assets. Instead of putting bonds in inventory in anticipation of investor demand, "dealers are now more likely to be the middleman or transact on a riskless basis," he explains. This practice has further curtailed analysts' need to write research reports on tax-exempt bonds.
The reorganization of sell-side bond research desks remains a work in progress. Although the BMA has urged dealers to address potential conflicts between research and trading, ambiguities remain. For example, the guiding principles state that traders must not take advantage of prior knowledge of the timing or content of a research report that may affect the market price of a bond, but the guidelines don't prohibit routine interaction between bond analysts and trading desks. Should there be a firewall between research analysts and traders?
"It's not as easy a question to answer as it might appear," says Marjorie Gross, senior regulatory counsel at the BMA. Analysts get useful market information from traders that helps them accurately value bonds. But customers may fear that communication between traders and research analysts gives the traders an opportunity to front-run research. Notes Gross, "If the risk of front-running were handled, then requiring a complete separation between analysts and traders would probably be unnecessary."-- Nina Mehta
The rankings were compiled by Institutional Investorunder the direction of Assistant Managing Editor for Research Lewis Knox and Senior Editor Jane B. Kenney with Associate Editor Donovan Hervig.