Does Independent Credit Research add Value?

Transcription

1 Does Independent Credit Research add Value? Julien Rerolle and Cedric Rimaud, Spread Research, France Spread Research is an independent credit research company dedicated to providing value-added analysis on the credit worthiness of high-yield corporates. Over the last five years, Spread Research has developed a robust analytical framework to analyse the rating of high-yield debt issuers, publishing both corporate rating indications and investment recommendations for the benefit of the investment community. Introduction Asset management firms, hedge funds and other institutional investors typically receive three kinds of investment advice: first, from the investment banks that are keen to promote their trading and investment banking operations; second, from the rating agencies credit ratings, for which the issuers themselves have to pay annual fees, and which are often used in the guidelines of an investment mandate; and third, from their own research analysts, who often rely on the research of the investment banks and the rating agencies, as well as other publicly available information. This article first reviews the current debate on the independence of each of these players as providers of fundamental research and presents a short study on the track record of a specific provider of independent credit research, showing that independent credit research can add significant value over time. A short review of some literature In their investment process, asset managers rely on external sources to provide them with sufficient information to select the best investment opportunities. In a recent paper ( Executive Comment: An Examination Of How Investor Needs Are Served By Various Ratings Business Models, April 2009), Standard & Poor s (S&P), one of the three main certified rating agencies, classifies these sources along three different business models: the subscriber-fee model, the government utility model and the issuer-fee model. The difference is mainly centred on the sources of the funds that finance this research: the investors, the taxpayers or the corporations issuing public debt, respectively. A lot of literature has been published on the effect of research on asset prices in the market for publiclytradable securities. Beaver et al (2006) make the distinction between the purpose of the research between the contracting role of certified rating agencies and the valuation role of non-certified rating agencies. The issuer-fee model takes its purpose in the need for issuers and investors to comply with listing requirements, as they are imposed by market regulators, and investment guidelines for mutual funds; therefore, it is of a contracting nature. The subscriber-fee model serves the need to perform an independent valuation of securities before choosing to buy or sell them. The government utility model would stand in between these two groups. First, let us review the role of the rating agencies. In its July 2008 Summary Report of Issues Identified in the Commission Staff s Examinations of Select Credit Rating Agencies, the Securities and Exchange Commission 31

2 (SEC) has singled out the problem of the issuer pay conflict, and has made several recommendations to ensure that changes are implemented to avoid that rating analysts be part of the fee discussions in the rating analysis. It does not, however, solve the fundamental issue of the independence of the analysis. Their fees are paid by the issuers of the debt instruments they rate; this is the first conflict of interest. Back in 1975, when the SEC created the Nationally Recognised Statistical Rating Organisation (NRSRO) status, ratings were remunerated by investors. Whether we should go back to the old model remains an open question. Those who followed blindly the ratings published by the rating agencies now understand that they must conduct their own research. Not doing so means being late to the game, at best. Some commentators, like Christopher Wright (2009), consider that the competition among credit rating agencies will bring benefits. He identifies three areas where new entrants can come a long way in asserting their competitive advantage: the timeliness of the information they provide, the quality of the research underpinning the credit rating and the management of their potential conflicts of interest. As early as March 2005 in France, the national regulator, the Autorité des Marchés Financiers (AMF) gave its approval for the creation of an association of independent credit analysts, the Compagnie des Analystes Financiers Indépendents (CAFI), whose goal was to promote the independence of research in the investment industry. But the debate has taken a new dimension, following the recent financial crisis. On 23 April 2009, the European Parliament approved a set of rules on credit ratings, asking rating agencies to stop providing advisery services and disclose their models, among other things. It is clear that the oligopoly of the three main agencies (Fitch, Moody s and S&P s), whose work is paid for by the issuers, lends itself to unfair practices that new regulations ought to control. The financial crisis is, in part, a consequence of the improper validation of the credit-worthiness of sub-prime borrowers, repackaged into complex financial transactions and given a false sense of security through a modelimplied rating. Discussions are also going on in the US, with the SEC reviewing ideas to regulate them. Regarding the research published by investment banks, several studies on its impact on financial markets have also been conducted. For example, Johnston et al (2008) show the effect of sell-side research on the pricing of market securities and single out its existence as a reason for the speedier release of new information into the securities market. Such effect also highlights a second agency problem, this time at investment banks. The joint issues of the soft commission system of investment banks, where investors pay for research through trading commissions and advisery mandates are not new. The fall of Worldcom and Enron, as well as many research papers published in the aftermath of these events, like Ljungqvist et al. (2005), have demonstrated the duplicity of sell-side recommendations coming from investment banks, which tend to follow their own relationships with the issuers, or the needs of the banks own trading desks in managing their positions. The large investment banks have willingly started to tighten their Chinese Walls and to segregate their research units from trading; the industry has been forced to pay large sums to independent research firms, although this has largely benefited the equity, rather than the debt, markets. Investors will probably remain suspicious, knowing the fees that the investment banks charge their clients for their advisery and syndication business. If sell-side research provided by investment banks does provide investors with timely information and serve their valuation function, non-certified rating agencies and other providers of independent debt research ought to provide investors with a superior level of service; their research is objective and solely at the service of investors. This should, therefore, play to their investing clients advantage. We would like to explore next whether their track record supports the thesis that they add value over time and, in particular, if we compare them with the changes published by the rating agencies. We tested for this on the model portfolio published by Spread Research, an independent provider of credit analysis on the European High Yield bond market. We reviewed the performance of Spread Research, an independent credit research firm founded five years ago to cover the European high-yield bond universe. In its five-year history, Spread Research has built a team of 10 analysts who follow the European high-yield sector, with a universe of nearly 100 companies across 12 industry sectors and across all European countries. 32

3 100 High-Yield Issuers 90% of European High Yield Cash Index 70% of itraxx Crossover Index 20% of European Loan Indices 15% of Issuers have issued Convertible Bonds 15% of Emerging Markets Corporate Bonds This firm publishes regular updates on the credit worthiness of bond or loan issuers. Each day, new information is reviewed by a team of analysts and analysed in the context of forecasting models. Quarterly results are anticipated and their release is promptly reviewed with an update provided to clients within hours of their publication. Its analysis is fully transparent: forecasting models are Excel-based and readily available to premium clients who can incorporate the data in their own investment decision process. Its services are geared towards asset managers and institutional fixed income investors. Macro-economic Off balance sheet Subordination Market Sectorial Rating agency Issue-specific covenant Event Regulatory Liquidity Forecast/Analysis Quarterly cash flow forecasts Stress scenarios Excel-based model Company reports, sector analysis, covenants reviews, etc Specials Recovery rate and debt adjustment based on proprietary models SR rating = six months forecast of the company credit profile Event is incorporated into the SR rating 33

4 Based on the firm s fundamental research, several layers of opinion are given for a bond or a loan: 1. a notation for the company s transparency on financial information; 2. a corporate rating: Spread Research publishes its view on the credit rating for the next six months, incorporating any event that could affect the company; 3. an outlook for its rating; 4. an estimate of the recovery rate upon default, depending on the seniority of the debt instrument; and 5. an indicator for the liquidity and refinancing of the company. Testing whether the research adds value We first compared the changes in opinion published by this firm with the changes made for the same debt issuer by S&P or Moody s. The dataset included 222 observations between October 2006 and March For each observation, we associated each published opinion with the credit rating issued by S&P or Moody s at the time. The hypothesis was that changes of opinion often preceded changes made at the rating agencies, something we found to be the case in 40% of cases, not to be the case in 18% of cases, and inconclusive in 42% of cases. If we consider a subset of only the changes that did precede a significant rating change at the certified rating agencies, we found that in 70% of cases, the provider of independent research was ahead of the agencies. 34

5 In the course of its business, Spread Research offers its clients a set of investment recommendations presented in the form of a virtual portfolio. Based on the published research, the changes in opinion are reviewed and combined into virtual bets as they become apparent from the bottom-up analysis. Within the portfolio, a name can be underweight (0% of the portfolio), market weight (2%) or overweight (4%). We then looked at the performance of this model portfolio against the market, represented by a public index. Testing for this positive skew is not easy. Many things can move the market value of traded securities. Also, the move has to be large enough so that trading in and out of the security makes sense, accounting for the transactions costs of the bid-offer spread, which can be high in this segment of the market. From October 2006 through March 2009, changes in the portfolio composition resulted in 175 occurrences on one of the 83 names in the model portfolio (monthly rebalancing over 33 months). These changes were mostly driven by changes in the rating outlook, but only changes in which the conviction of the analyst was high made it into the model portfolio. For each name, the change in the bond spread relative to the change in the average spread of the 83 names, following the change in the recommendation, is reviewed. Through this examination, the change that is due to the company-specific reasons, rather than the overall changes due to the overall market appetite, is extracted from the issuer s credit spread change. Looking at the same dataset, we looked at the breakdown of good calls (a rating that is lowered is followed by a widening of the credit spread, after adjusting for the move of the wider market) versus bad calls (a rating that is lowered is followed by a tightening of the credit spread). Spread Research s hit ratio is close to 60%, after adjusting for the change in the average spread change of the universe. That is, in 60% of cases, a recommendation given is followed by a move in spread in the correct direction (a widening in the credit spread after a rating has been lowered or a tightening after a rating has been increased). If we look only at the spread changes that exceeded a certain threshold, to account for the likely bid-offer spread that one may encounter when implementing the trading strategy, this success ratio even increases to reach 70% for spread changes above 50bps. Looking at the total return of the model portfolio against the broader indices, like the Merrill Lynch Corporate Bond indices, also confirms that a strategy based on Spread Research s recommendation adds significant value over time. 35

6 Our study clearly shows that debt research can add value over time. Compared with the results of the certified ratings agencies, this value comes from the fact that the research can be released in a timelier manner, thus, largely benefiting investors who can take advantage of the time lag of security prices to adjust to new information. The future of research and its relationship with asset managers An external investment researcher can also serve asset managers in several ways. First, costs should be lower. Running large research teams internally can be quite expensive, as corporate financial statements must be analysed and modelled, each quarterly results bringing new information, on top of the daily monitoring of news that can sometimes change radically. Some of this work has already been outsourced to cheaper places, like India, where new data providers offer several layers of services to service investment banks, asset managers and financial advisers. The that the analysis may become commoditised does exist, and a fund manager is likely to request from an external data provider an extra level of analysis that only experienced credit analysts can perform. Small markets can also be the most difficult to analyse, if the information is published only in the local language or some of the regulatory framework is different from larger markets. The current investment landscape is one where the rating agencies will certainly retain one form of proeminence, given how deeply entrenched they are, and also because it would require a tremendous effort for the many funds in the world to change their investment guidelines or allow for a different kind of practice. Investment banks will also continue to provide some research, but the trend is on reducing costs drastically there, so it is likely that they will continue to carefully monitor how they reward their research teams and the headcount costs associated with such units. The third path is one where smaller firms can compete against larger players, benefiting from a greater independence and more flexibility to adjust their services to respond to the needs of their asset management clients. Competition will probably intensify among these firms and each one will be looking to develop its own niche market. Asset managers will increasingly see the value of such independent research and, if they accept to pay for their services, it is likely that they will also see many 36

7 benefits in receiving advice that is independent and that can guide them into new markets without requiring a huge investment in headcounts. This will allow them a greater flexibility to move into illiquid or less developed markets where information is more difficult to get, and the rewards of wellinformed investment bets are bigger. References: Beaver, W., C. Shakespeare, and M. Soliman. Differential properties in the ratings of certified and non-certified bond ratings agencies, Journal of Accounting and Economics, 42, , Gurun, Johnston, Markov. The effects of sell-side debt research on debt and equity markets, April Christopher Wright, Run, Big Three, Run. Is increased competition the right therapy for ailing CRAs?, CFA Magazine Vol 20, May/June Ljungqvist, Marston, Starks, Wei, Yan, Conflicts of Interest in Sell-Side Research and the Moderating Role of Institutional Investors, September Julien Rerolle Head of Credit Research Spread Research julien.rerolle@spreadresearch.com Tel: Cédric Rimaud Senior Credit Research Analyst Spread Research cedric.rimaud@spreadresearch.com Tel: