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European investors regained their appetite for credit risk in 2003. From a high of 1,398 basis points late in 2002, junk-bond option-adjusted yield spreads narrowed to 392 basis points by the end of 2003. The diciest part of Citigroup’s bond index -- CCC-rated credits -- returned a whopping 46 percent for the year, besting the overall corporate market’s solid 8 percent return. Bolstered by stronger economic growth in the U.S., Asia and parts of Europe, emerging-markets sovereign debt issues on average provided a robust total return of 26 percent. Perhaps the clearest signal that the market was comfortable with risk: Russia’s sovereign debt returned 22 percent; in the fall, Moody’s Investors Service deemed the country an investment-grade credit.
“In 2003 if you went long on the credit market you would have made money,” says Katherine McCormick, head of corporate credit research at J.P. Morgan. “In fact, the worse the credit, the more it tightened.”
Now, however, investors who feasted on high-yield debt are wondering whether it’s time to push back from the table. U.S. and U.K. interest rates are rising from historic lows, threatening to add to borrowing costs and slow business growth, particularly in industries -- or countries -- still mired in debt. Emerging-markets debt has lost 4.4 percent so far this year. Yet, European high-yield bonds have continued to outperform with a return of 3.87 percent in 2004 through early May, which is 2.70 percentage points better than duration-matched government securities. As a result, spreads to comparable government securities have narrowed further to 322 basis points.
It’s up to Europe’s bond analysts to make sense of this new environment for investors. After all, Vivendi Universal’s debt may have been a bargain at 1,400 basis points over asset swaps in September 2002, but what about at 100 basis points over in May 2004? Will European rates go sharply higher? Is the region’s nascent recovery going to be cut short? Where can investors pick up a little extra yield without taking on too much credit risk?
“Last year we put a lot of effort into getting the right sectors. This year the sectoral bet is worth less,” explains Alan Capper, head of portfolio credit strategy at BNP Paribas. Instead, Capper is focusing more on the long-term relationship between the supply of savings, which will rise as Europe deals with its pension crisis, and the supply of corporate bonds. Unless rates rise dramatically, the additional savings should help absorb bond issuance and keep downward pressure on spreads, says Capper.
Analysts must rejigger their strategies even as they come under close scrutiny themselves. Beginning next month U.K. regulator Financial Services Authority will require brokerage firms to guarantee that their fixed-income research is “objective.” It has left the exact details to the brokerages, but most firms have had to devote considerable energy in the past year to figuring out how to separate their client-supported research from their proprietary trading. “Morgan Stanley has spent a lot of time thinking about conflicts of interest at the very highest levels of our firm,” says Catherine Gronquist, the firm’s director of international credit research. Part of the solution: Morgan Stanley’s credit analysts are being segregated from the rest of the trading room to help comply with the new FSA policy.
Regardless of from where it emanates, authoritative fixed-income research is vital to investors, particularly in times, like these, when the markets appear to be changing course. And for the second year in a row, investors point to J.P. Morgan as the source of the most insightful analysis; the U.S. bank secures 13 positions to place first in Institutional Investor’s All-Europe Fixed-Income Research Team, nosing out Deutsche Bank, which repeats in second with 12 team slots. Citigroup climbs five places to third this year, gaining six team slots for a total of ten, while Morgan Stanley eases from third last year to fourth, even as it adds one team position for a total of nine.
Since October 2002 these and other firms have found their best investment ideas in the junk bond market, which lagged other types of European bonds in the stellar markets of 2001 and 2002. Sven Olson, who leads Deutsche Bank’s top-ranked team in High-Yield Manufacturing/General Industrials, recommended in August 2002 the bonds of Swedish refiner Preem Petroleum, which had sunk to 63 because of record-low refining margins. Olson thought the company had high-quality assets and sufficient liquidity to ride out the tough times. Last April, as the underlying refining market improved and the bonds moved close to fair value, Olson went to hold; investors who heeded his advice enjoyed a total return of 66 percent; in early May 2004, the bonds changed hands at 101 to 102.
In retrospect, such picks may seem “easy,” says Patrick Hendrikx, head of global credit research at F&C Management, which manages E45 billion ($54 billion) in European bonds. But he notes that “at the beginning, 2003 looked like it was going to be the same awful year as 2002, when a lot of corporates had high leverage, the wrong balance for financing and big liquidity issues.”
The fact that some of Europe’s biggest and best-known companies dropped into the junk category last year only heightened the market’s appeal. In all, 14 fallen angels with total debt of E24 billion became high-yield issues in 2003. Among them were Swiss engineering giant ABB, as well as its German counterpart ThyssenKrupp, British Airways, HeidelbergCement and French chemicals company Rhodia. “A lot of people got comfort because huge market caps were introduced to the sector,” says David Newman, managing director and co-head of European Credit Research at Citigroup. The key, he says, was “to spot which companies were merely stressed -- they had just a bit too much debt for their previous ratings -- and which ones were distressed -- that is, there were serious issues that would involve restructuring.”
One good bet turned out to be ABB. In November 2002, Newman, who leads the No. 2 team in High-Yield Manufacturing/
General Industrials, recommended ABB paper after CEO Jürgen Dormann outlined plans to restore the company to financial health by cutting costs, reducing leverage, selling businesses and managing the asbestos liability of a U.S. subsidiary, Combustion Engineering. ABB achieved many of those goals, and a U.S. court ruling in July 2003 gave preliminary approval to a prepackaged bankruptcy plan for Combustion Engineering, capping its asbestos liabilities at $1.3 billion. ABB’s 2008 euro-denominated bonds doubled in value from 57 in November 2002 to 114 in May 2003, for a total return of 140 percent.
Of course, some former angels fell further and faster than others in 2003. After a month of press speculation about its finances, Parmalat in December revealed that an account with approximately $5 billion in assets did not exist. Within days, the respected Italian dairy products maker’s debt plummeted from the mid-90s to high single digits (it has revived to the low teens since); Parmalat filed for bankruptcy protection at the end of the year; it owes creditors some $17 billion.
Parmalat executives’ initial dissembling about its problems also produced one of the year’s best calls. Thomas Mazarakis and his team at Goldman Sachs International put out a report on October 10, 2003, a full month before the irregularities surfaced. After a Parmalat analysts’ meeting at the end of September, Mazarakis grew suspicious. In his follow-up report the analyst wondered why the company’s accounts showed a big cash balance that wasn’t being used to pay down debt. “We came away feeling very skeptical about the financial management of the company. They had very weak justification for maintaining all that cash,” says Mazarakis, whose team retains second place in Investment-Grade Consumer Products. “At the end of the report, we wrote that we were ‘not comfortable recommending Parmalat bonds to investors.’ That’s not the sort of language we normally use.”
More recently, analysts have begun searching for ways investors can obtain incremental gains in yield without loading up on credit risk. Structured products are one alternative. “A lot of investors are looking at [collateralized debt obligations] and how they can incorporate that type of structure into their portfolios,” says Capper, who heads the No. 3 team in Investment-Grade Strategy. Senior CDO tranches, for example, can offer high credit quality and still pay a premium over investment-grade interest rates.
Commercial mortgage-backed securities, another structured product, also offer promise. A five-year, floating rate, triple-A CMBS pays a spread of 27 basis points over LIBOR, while comparable corporate floaters pay just 4 basis points over LIBOR. The spread between triple-A CMBSs and corporates has narrowed by 31 basis points since the end of 2003, which “shows that investors are taking advantage of this,” says Howard Esaki, who leads Morgan Stanley’s No. 1 ranked Asset- and Mortgage-Backed Securities team.
Next month, many researchers will begin evaluating the markets from a whole new vantage point -- far away from the bond trading desk. In response to the tainted research scandals in the U.S. -- and the new U.S. regulations governing impartiality of research -- securities dealers in Britain must take responsibility for ensuring that research advertised as objective is in fact impartial. As outlined by the FSA, potential conflicts of interest could include having analysts participate in new-issue marketing, having the trading desk take a position to benefit from an upcoming research report or having an analyst issue a report to favor an existing trading position. The firms have been left to craft their own responses -- for now.
Morgan Stanley, for example, has restricted analyst participation in underwriting pitches and deal marketing since November 2003. More recently, however, it has prohibited the researchers from receiving any information about the firm’s trading positions, and it has also forbidden sales and trading staffers from knowing anything about the timing and content of upcoming research.
To this end, the firm is in the process of dividing most of the research department from traders using glass walls with doors operated by electronic key cards. “It’s odd, but a modern building can’t put up a glass wall all that quickly,” says research director Gronquist. “But it’s very consistent with the FSA’s thoughts on impartiality and creating research in a clean-room environment.” The analysts have always been seated on one side of the floor, well away from the traders.
Morgan Stanley will make one other change. Bonus packages will no longer be tied to the performance of any specific product area or trading desk. “There will be new measures of personal performance,” says Gronquist. She anticipates that feedback from buy-side clients will affect the size of analysts’ compensation next year.
If so, the sell-side analysts have reason for optimism. II asked the buy-siders who voted in our All-Europe Fixed-Income Research Team survey to rate overall research quality. In 2004, 34 percent of those expressing an opinion were “very satisfied” with brokerage research, compared with 19 percent in 2003. Investors, of course, may feel a little more charitable after a long bull market. There’s no assurance that will continue.
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The rankings were compiled by Institutional Investorunder the direction of Assistant Managing Editor for Research Lewis Knox and Senior Editor Jane B. Kenney with Senior Associate Editor Tucker Ewing.
