insto - Australian financial markets

Invest Global, Research local

A group of sell-side and buy-side debt market participants spent some quality time in the wake of Insto fixed income poll discussing what each side expected credit research to deliver.

ATTENDEES:

• Michael Bors, Credit Research Analyst
  Commonwealth Bank of Australia
• Adam Donaldson, Head of Debt Research
  Commonwealth Bank of Australia
• Peter Fullerton, Head of Credit Research, Australia
  Schroders
• Bradley Gibson, Head of Interest Rate Strategies
  ING Investment Management
• Peter Hendry, Head of Global Institutional Sales – Fixed Income, Institutional
  Banking & Markets,
  Commonwealth Bank of Australia
• Phil Miall, Director, Senior Credit Analyst
  UBS Global Asset Management
• Bernard Kellerman, Editor, Insto

INSTO: What do you see as being the most important effect on credit research in the current environment?

Bors: I think the role of credit research somewhat cyclical. Pre-crisis it was of less relevance given the huge influence of the technicals, but now it has definitely increased in importance to both debt and equity investors. I broadly see the role of sell side credit research in helping clients make well reasoned decisions to buy and probably more importantly avoid securities from a bottom up perspective.

Donaldson: I think Brad and I are both coming at this from the macro end of the scale, given it was a macro and fixed income poll. We can bring a number of perspectives to clients through the information we gather at an institution like Commonwealth Bank that they are not able to see as readily themselves, so we are partly about information gathering and actually collecting things that they can’t see, but also we’re applying a broad range of analytical skills to the same information that is giving them a perspective on markets that sometimes might challenge their own thoughts and to get them to think differently.

Fullerton: Schroders has a global credit research capability, so any research that comes from a sell side or from rating agencies is one of the inputs into our research process. We are always looking for different, well researched views but, at the end of the day, we make our own investment decisions. Internally, we have dedicated credit analysts who feed views and trade recommendations to the portfolio managers.

Miall: It’s similar for UBS in that we have a global credit research team - we do our own research and assign an internal rating for each issuer. Certainly, sell side credit research is one input into the process but there are a range of sources that help to form our view. I’ll regularly read commentary from the sell side analysts, but how much attention I pay to it will depend on what their view is. If it’s significantly different to our own thinking its more likely to catch my eye as I’m interested in what shapes the different opinions.

Donaldson: Well, one of the interesting things about Commonwealth Bank is that we are clearly known for our domestic strength rather than global presence. But we do think that when it comes to analysing the corporates in the Australian economy, or understanding the Australian economy and the way our market works, some of the flows in the market and the information there, we do bring quite a bit to the table. But we’re never entirely clear on how important that is for the clients and where they place most of the importance.

Miall: I tend to agree. In terms of credit, coverage of domestic issuers is a strength of the sell side research provided by a number of the domestic major banks. The slight conundrum is that kangaroo issuance has become a reasonable component of the index, and perhaps that’s not a particular strength of the major banks. For UBS, given our global coverage, the latter is not an impediment and we appreciate more thoroughness on the domestic names.

Fullerton: I would say the key is the quality of the research that you put out and the value add in that process. From a logistics and practical point of view, to have analysts on the ground in the actual location of the issuer is an advantage.

INSTO: Michael, you’re one of those research providers.

Bors: From a sell side perspective, it’s a challenge to find a model, because one size doesn’t fit all. There are clearly some clients that are structured where the local analysts are solely responsible for the local names and others where they are not part of the global house and are responsible for everything. We try to do both and do recognise that our comparative advantage is perhaps on the more local names. The concept of having local knowledge in credit markets has only come to fruition with this crisis. Credit markets are a bit like real estate markets in this respect. I believe it’s important to have the local knowledge there, particularly to be able to participate in conference calls, have access to company management, which may or may not necessarily be displayed in the report writing, but it certainly helps build knowledge over time of the individual issuers by being located in the same location.

INSTO: We might get onto the issue of independence. Our previous fixed income polls showed a fair degree of cynicism among the investors as to how independent the banks’ research was. What would you view as good, independent research? And would you pay for it?

Miall: I guess what we’d view as good independent research is research that’s not influenced by the other capital markets areas in the banks. I think the independence of sell side analysts has been quite reasonable in recent times, but at the end of the day UBS’ view is based on our internal bottom-up research.

As to whether we would pay for sell side credit research, we haven’t canvassed that internally. However, given UBS has a global team of credit analysts I’m not sure we’d have a strong willingness to pay for it.

Hendry: On the credit side you’re not, but on the equities side of your business there are, I would think, fairly regimented approaches to how you direct your commission and reward brokers. All of that could be based on the research that’s provided. I guess we just wonder, from the side of the market that we sit on, how it has evolved that these things are so completely different and what’s behind that? At the end of the day, if it is something that’s pointless for us to provide to the client base, then there’s a question as to why it’s done, and would you be missing out if we ended up going down that route?

Fullerton: Well, I’ll jump in there. We’re looking for timely, insightful, forward looking opinions. We’re looking for an opinion that is well thought out and well structured. Because we’ve seen that the agencies aren’t infallible, investors are looking to spread a wide net in terms of getting information for that process.

The inherent limitation with the credit rating agencies is that they can be slower to move, slower to react on their rating changes. They take a longer term outlook, often 5 years, for investment grade ratings. There are opportunities for other analysts to provide some relevant, timely analysis that can have a shorter term focus, as well as an eye on the longer term.

INSTO: Where do you sit on this, Brad?

Gibson: I’d like to approach it from the rates angle, as opposed to the credit angle.

Would the buy side pay for sell side research? We think we do pay for that, and certainly the quality of research has an impact on who we deal with. For ING Investments, it’s certainly one of the boxes that needs to be ticked for us to execute significant interest rate swaps, futures deals, bonds, semi-government trades, over the counter options deals with our counterparts. We rely heavily on access to banks and their activities, particularly the domestic banks. They do have some insights into the domestic economy that not everyone has, so having a good relationship with that bank is profitable to us and to our clients, and we seek to reward them.

Fullerton: I’ll just add to that. As investors, we’re paying the agencies for access to their research, so there already is a user-pays model for research. It’s just how that money is allocated. That said, given the current environment, everyone is focused on cost control, so that would be a limitation in the short term.

INSTO: The investors have said they get sources of information from everywhere. Do you use not just credit research, but equity research?

Gibson: We use equity research as one of the inputs in our financial model, because they’re doing fairly comprehensive financial forecasts for debt and earnings in particular – that’s a key input we’re looking for. But also in this current environment, a lot of issuers relied on equity raisings. You need to get a sense of what sort of support they’re going to get from the equities market if they’ve got significant debt maturities, because it’s got a significant impact on credit profiles with the equity raising recently.

Hendry: Only in the last 18 months. No-one cared before.

INSTO: So, what has changed in the last 18 months for you?

Hendry: Just exactly that. You go to the equities briefings now, and all they want to know about is the debt profile. So it’s done a complete about turn, which is interesting.

Bors: I certainly think there’s opportunity to integrate credit and equity research more, particularly with the use of financial forecasts. There are certain synergies there, too, beyond the financials, in terms of being able to tap equity colleagues for industry specific knowledge. So it’s definitely something we want to do more of in the future.

INSTO: And what about government guaranteed debt, is there a need for research, or is it pretty straightforward?

Fullerton: There is a need for research on it.However, it requires a different skill set than traditional credit research.

Gibson: Yes, there is a lot more time being spent on the creditworthiness of sovereigns and the recent widening in their CDS spreads – if you can believe the CDS market is indicative that there is probably an element of credit in some sovereigns.

The government guaranteed market, the banks and now the semi-governments – there is no structured component of them, so the difference is the liquidity and the longevity of those markets. There should always be a premium for liquidity, and certainly the last 18 months have taught us that lesson.

INSTO: Investors in some markets are still relying on the credit rating agencies, and the credit rating agencies are going to change their approach, to become more regulated. Does that change your view of any of the information they’re going to be providing?

Miall: Some mandates have an imbedded link to ratings, for example in relation to concentration limits, so for those mandates it’s something we’ll continue to pay some attention to. In terms of implications from regulatory and other changes, we’ll have to wait and see how these potential changes affect the ratings and research the agencies provide.

Fullerton: I think what we’ve seen through the crisis is that some investors over relied on the opinions of the credit rating agencies’. Investors having their own internal credit research function and spreading the net wide in terms of the information sources can help to lower that sort of exposure to a single entity or set of opinions.

Bors: The role of credit research is really, in that context, is to provide something that’s different to what the rating agencies provide and/or critique their work where appropriate.

Donaldson: I wanted to pursue the compliance issue further. We’ve seen a number of banks go to a sales desk type model for credit provision. We need to assess whether that’s an appropriate model for a bank to deliver research from, or whether it’s better that we try to maintain the independence that we do. I was interested to hear what the feedback was from investors on that particular subject. We did hear they considered most of the research they’ve been seeing is independent, but does that actual difference in where the analyst sits really change your perception on what you’re getting from them?

Miall: I’ll consider each trade recommendation or piece of research on a case by case basis. But quite possibly yes, it would change your perception of independence. However, as Peter mentioned earlier, it comes back to the insightfulness of the research, how forward looking it is and the reasonableness behind the views that are expressed.

Hendry: Even in the case of new issues? A big issue?

Miall: For an inaugural issuer I think you may have more caution about the independence of research produced under a sales desk model. This partly reflects that fact that it’s a new name and there may be a range of opinions about its credit quality and credit risks. That’s not to suggest the sell side analysts would publish research that conflicts with their actual views. Its perhaps as much a matter of perception.

Fullerton: What I’d add to that is sell side research is an important component in the whole process, because they can give important information on what the street is thinking, the flows that they’re seeing, how the markets are reacting, which is just another input for us in that decision making process. So it adds value in that respect.

Hendry: No, I was just wondering that when it comes to new issues, if you pick a big name – say Woolworths – and people say, “We want to see comparisons of what a like industry is like overseas” and so forth, I was just wondering whether that’s relevant? Often there’s different home synergies at work. In the UK, Tesco versus Woolworths.

Fullerton: I would say there’s a lot we can learn from overseas, but we are inherently a unique market. Most of our segments are oligopolies. We’ve got entrenched players who compete rationally. I know from my experience as an analyst at Moody’s, when you are dealing with offshore analysts, you do actually have to spend a reasonable amount of time explaining to them how the market works in Australia. It’s not like if you understand Tesco, you can understand Woolworths. You’ve got to keep in context. They’re very similar but also very different markets.

Bors: I think the issue about an international capability starts getting interesting for Aussie corporates where they’ve got offshore operations, because historically that’s the type of strategy that’s put a lot of companies in more trouble than the domestically orientated names. So being able to have insights into what Aussie corporates are doing overseas is particularly important.

I can think of a number of names, like Lend Lease or GPT, that have had strong domestic franchises but have blown lots of capital away in offshore expansion. So, it’s not just about being able to understand what’s happening domestically, but what those companies are doing offshore too which is really important.

Bors: I think the quality has definitely improved over time, and that is just a function of certain individuals being in the market for a longer period of time, too. When the markets really started growing, it wasn’t unusual to see analysts that hadn’t had exposure to previous credit cycles, and I think we’ll all be more wiser from working through this cycle, too, for next time.

Fullerton: Credit research is a function that is very important through all stages of the economic and liquidity cycle. However, it’s during periods when liquidity dries up and/or there is an economic downturn that you see the real results of your credit research and corresponding investment decisions. The benefit in identifying the poorer quality credits and deciding not to invest in these issuers during the good times, only really becomes apparent in a downturn when default rates increase.

What we’ve seen is that markets go down just as they go up, liquidity dries up, and access to capital is a major issue. So, it reinforces the value of good credit research through the cycle.

Bors: In the later part of the previous cycle, would it have mattered how much research was done into individual names when risk was so homogenous? Arguably there was little opportunity to implement bottom up views in a way that could protect absolute returns.

Fullerton: The differences in spreads wasn’t significant at all to justify the difference in underlying credit profiles.

Bors: Yes. So the point now is the market is much more conducive to research being useful than it is when spreads are super tight. And the buyers of a lot of that product such as the SIVs weren’t necessarily research driven.