August 2009

CREDIT RESEARCH: What lies beneath

Paying for independent credit research has advantages when digging into company performance, say Julien Rerolle and Cédric Rimaud, of Spread Research. iceberg.jpgCorporate bond and fixed income fund managers and investors often wonder what their information advantage is. The information available to them can come from three sources: companies, investment banks and rating agencies. But the fact is, none of them are completely independent.

Companies are biased to draw a favourable picture of their business and their forecasts are often optimistic.

Investment banks or brokerage houses, meanwhile, provide research to investors either because they have done the primary issuance or because they receive trading commissions. They may also sometimes end up pushing some investment ideas that favour them (because they hold a position, for example). Banks have created Chinese walls to prevent that conflict. But many research units have been hit by the financial crisis and scaled back. Also, many banks still maintain a special link with their corporate clients for their trading and investment banking businesses. A ‘sell’ recommendation may not bode too well if the client is yet to be convinced of doing the next corporate bond issue.

Rating agencies have their own flaws. They rely on commissions from the companies they rate and, as the global financial system tries to mend itself, their model is coming increasingly under the spotlight. Regulators on both sides of the Atlantic are reviewing their business model. Europe released some guidelines on April 23, 2009. Its conclusions are that there is a pressing need for a better disclosure of their methodology.

In a recent paper (Executive Comment: An Examination Of How Investor Needs Are Served By Various Ratings Business Models, April 2009), Standard & Poor’s, one of the three main certified rating agencies, defined three different business models: the ‘issuer fee’ model, the ‘government utility model’ and the ‘subscriber fee model’. The difference between these three categories mainly comes from the sources of the funds financing them: the investors, the taxpayers or the corporations issuing public debt, respectively.

Credit rating agencies are likely to remain a valuable source of information for regulatory and historical reasons. They bring to the market a uniform way to evaluate the risk of various kinds of investment, although their methodology can sometimes be opaque and their assumptions are not public. Many mutual funds also limit the downside risk of investing at the lower end of the credit spectrum and their investment guidelines typically contain a rating floor on the securities they can buy.

A research paid by a tax or by any other kind of government subsidy is likely to be inadequate. Very few investors would rely solely on such information.  

Subscriber fee model
Independent debt research does exist and it should be made more accessible. Based on a ‘subscriber fee model’ (those who need the research pay for it), it allows investors to get an expert’s view without having to recruit a team of full-time credit analysts. Several players have created a business model based on providing real-time news to investors, but getting the news is not enough. What really matters is the analysis that is performed on the basis of that information. That’s where the value is: understanding the changes in the debt structure of a corporation and choosing to buy or sell it is what differentiates fund managers.

In 2005, the French regulator recognised independent research as an integral part of the investment landscape and endorsed the creation of CAFI, an association of independent research providers.
Investment-grade names are widely followed and many players in the market offer a view on the business profile of the larger companies. The leveraged loan market is more private than the bond sector: for both, good advice can be difficult to get, in particular when the capital structure is complex. The market for high yield bond and leverage loans in Europe is complex and illiquid. The primary market had been shut since July 2007, but in the second quarter of 2009, primary issuance has come back to life with several new issues and bond indices, posing their best returns ever.

Question of survival
Admittedly, the outlook for speculative-grade debt issuers remains cloudy. Several issuers are in the process of asking their bank syndicate or their bondholders to accept a change in their debt covenants. Many others have exchanged their old debt for new debt with more favourable terms, leaving bondholders at a loss in their holdings. This is a question of survival for many of them, as their cash flows deteriorate on the back of the worsening economic environment. Getting the name-picking right is crucial in this market. This can be performed by someone who understands well how a capital structure can change over time.

One solution is to outsource research to specialist units, which do not share any ties with the banks, the bond issuers or the rating agencies. The annual fee is far cheaper than hiring a team of analysts. The analysis can easily be integrated within the investment process and tailored to a subset of names, if, for example, an in-house analyst already covers a part of the universe.

Paying for credit research is not common today, particularly Europe. It is likely to bring many benefits to the investment community, though. It is necessary to analyse thoroughly the value created or destroyed by corporations as they issue, swap or restructure their debt in the market or through private placements. As regulators seek new ways to reshape the financial industry for the benefit of its many participants, a special place should be given to this particular kind of independent financial advice.

©2009 funds europe

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