Running on empty?

Liquidity, or the lack of it in the secondary markets, is a source of frustration for credit investors, and with the trading environment getting worse, banks are coming under fire over the level of commitment they provide. Should credit trading desks be running with more fuel in their tanks or is this criticism unjustified? Hardeep Dhillon reports.

Credit research has come a long way in the past three years, as a greater flow of relative value ideas and the analytics to support them have been put at the disposal of increasingly savvy fund managers. The opening-up of this information tap should in turn have positive ramifications for turnover in the secondary market, in theory at least, but there is a snag.

Liquidity remains a misnomer for the credit market, or large segments of it, with investment banks’ credit trading desks on high alert for further Enron lookalikes, nervous about the direction markets might take, and consequently battening down the hatches.

That has been the cue for general disgruntlement among fund managers, who perhaps legitimately are wondering at times where the value of relative value is, if trades in many instances remain hard to execute?

Jennifer Chirrey, investment-grade corporate bond fund manager, Abbey National Asset Managers, is one such investor. “What we look for is the ability on the research side to generate relative value ideas on the one hand,” she says, “and on the other to be able to transact those ideas. It is one thing coming out with research advocating a transfer out of sector A to B, but if the trader does not want to execute that trade, what can you do? This tends to be a regular occurrence.”

“There is a lot of cautiousness in the market,” adds Chirrey. “There is no obligation at all on traders to make a price on a bond if they do not have a position in it, and more often than not, they just body-swerve it.”

Marino Valensise, Baring Asset Management (BAM)’s head of credit, is similarly unimpressed by the level of secondary market liquidity. “If we want to reward an investment bank for its research services,” he says, “we usually include that broker on our trading list and then we try the broker out on specific trades we have to do. It may well be that we are not able to reward the people who have provided the research, because the pricing is absolutely off the mark.”

Adds Valensise: “The banks are selective in their trading business. They always want you to go with a round market lot, trade only on-the-run credits and deal at a price they think is a good one. It is increasingly difficult to get multiple competitive prices – it just doesn’t work that way.”

Valensise says some investment banks are more accommodating when clients need to build their portfolio, as the banks are looking for an order on the entire portfolio of bonds. But, he says, “the whole system is falling apart, as most of the time, in order to structure portfolios that make sense, we have to buy bonds that are not on-the-run benchmark bonds.”
“If it were left up to the brokers, we would only trade in autos and telecoms; that is their idea of liquidity. As soon as you want to buy or sell an off-the-run industrial name, they panic,” he adds.

Asset managers are themselves not entirely free from blame for the less than well-oiled wheels of the secondary market. “Liquidity is fairly poor and that is as much the fault of clients as banks,” says a sell-side credit strategist. “Clients are still net buyers of credit, and therefore reluctant to sell anything unless it is an obvious credit story like a WorldCom, Enron or a telco name. Fund managers will say liquidity is awful but that is partly down to them as well, because they only want to sell when a credit gets a bit toxic. If they are to obtain better liquidity, they will have to be prepared to provide some from their side.”

More probably, a vicious circle will continue to perpetuate itself. “Things have been getting worse,” says BAM’s Valensise, “and the banks just want to trade in their sizes. This leads investors to trade less. In today’s market, trading is more difficult and also costs more. The only place where trading is cost-effective is in the new issue market. Overall, buy-side turnover, excluding new issues, has decreased in the first six months of this year and that is going to make the banks suffer. It seems clear to me that they won’t make as much money as last year.”

If that turns out to be the case, it will not simply be because investment banks are pressing the panic button out of fear of what the market might do next. Some banks are still reeling badly from the damage that has already been done. Schroder Salomon Smith Barney (SSSB) is a case in point, with one investor singling the bank out for the way it has drawn back from the secondary market. “If you look at the blowouts – WorldCom, Tyco, Ericsson, SSSB is involved in all of them,” the investor says. “They have historically been strong in research, but they used to have five telecoms traders and now they only have two.”

Investment banks disagree that they are shirking on providing adequate support in difficult markets, and sell-side analysts say that while the ability to execute on the back of recommendations at all times and at the best price is clearly the ideal, the generation of ideas from the research side is an end in itself. “We always strive for executable ideas,” says Catherine Gronquist, head of European credit research at Morgan Stanley. “You can, however, make cross-sector recommendations which clients may or may not execute. This steers the debate towards how rich or cheap that sector is – that is the value.”

Adds Rick Deutsch, head of European credit research at BNP Paribas: “A trading idea should be part of a package – you provide the idea and you should be able to transact it.” Deutsch admits, however, that reality can dictate otherwise. Clients always want the best advice at the best price, but in any trade the bank wants to break even at least. “It is very difficult to give up that last basis point,” he says. “Investment banks providing liquidity is one thing, but it is up to the investors to reward that liquidity.”

Recent bid offer spreads in different parts of the market do, however, paint a gloomy picture. Henderson’s Reedie says one factor adding to deterioration in spreads is the fact that there is less capital being used in market-making operations by investment banks. “It is difficult to make prices as there are no natural sellers of credit,” he says. “For fund managers to exit bonds, a liquid capital market is required.”

Bonds are being defensively priced, he adds – a consequence of the depressed capital markets, low equity valuations, lack of investor confidence and ratings actions. “A switch from the bid to offer spread is on average in the 10-15bp range,” he says, “but this could balloon out to 100bp if you take some of the telco names, such as Deutsche Telekom and France Télécom.”

Valensise agrees pricing is often “way off the mark”, and the extreme differentials lie in those triple-B names that are not heavyweights in the index. “Market sentiment is totally news-driven,” he says. “You could see a 5-10% gap or the bid may even disappear in the European high-yield market. All the telco bonds and some industrial names, such as Ineos Acrylics, for example, lost five points immediately on the back of negative results. At the most you’ll trade a block of three million bonds, but on the whole it’s a one-by-one market.”

Most of the issuers in the European high-yield arena, adds Valensise, at one time or another have experienced wide bid-offer spreads. Off-the-run industrials are truly dire and experience the greatest volatility. The real bid in the market is two or three points below, adds Valensise, Neste a high-beta, low quality chemical name has a three-point differential in the bid and offer.

Many of the safer industrial credits, such as Kamps AG, Ineos and Messer Griesheim trade with one point difference, but Xerox has tightened in to just a three-quarter of one point difference after the confirmation of its bank lines, says Valensise.

Dissatisfaction with the merry-go-round which, particularly in current markets, can be an investor’s lot when searching for executable trades leads some fund managers to comment wryly on the model portfolios run by the banks. “I still have to see one bank that loses performance on those portfolios,” says BAM’s Valensise. “Everyone is making money on those paper portfolios, which to me is a miracle statistically. I still haven’t seen one that underperforms, so I have to be sceptical. It is not clear when or at what prices they trade; additionally, they have access to perfect liquidity on a model basis, which is something very different to real life.”

Model portfolios, though, can still give investors valuable information, he says. “They give you an idea of how confident any sell-side house is on a specific credit. The data from model portfolios is useful, but this information has to be interpreted.”

Colin Reedie, head of credit portfolio management at Henderson Global Investors, agrees that these paper portfolios do not suffer like asset managers from a liquidity standpoint of moving reasonable sums of money from one bond or one sector to another. “But it is still a good steer,” he says. “If you aggregate all these different model portfolios up, you get a good idea of where the street consensus is on any given sector or stock. As always though, it is how you use the information in conjunction with your own analysis that will determine the results. But, it is fair to say that in structuring themselves this way [credit strategy and analysis backed by model portfolios], the banks are tackling the kind of issues that we face every day.”

Frontrunning (giving internal clients the edge over external ones when announcing views and recommendations) is a more legitimate point for investors to feel sore about. The book has to be positioned so customers can trade on it, depending on the bank’s view, long or short, says BNP Paribas’ Deutsch. “Ideally, you are positioning for your credit view and simultaneously positioning so clients can act. Things become complex when this thin line becomes blurred. My recommendations are always with the customer transaction in mind but it is largely a matter of a house’s philosophy. Where there is more of a proprietary trading focus, the issue of frontrunning can be more problematic.”

Despite these niggles and the difficult trading environment, many banks are now offering a more coherent package across trading and research than in the past. In particular, some – though not all – banks have gone down the road of integrating credit trading/sales and research, and are keen to emphasise the benefits that this brings to investors. The comeback from investors, of course, is that integration is good in theory, but the proof of the pudding is in trade execution. “For integration to really work,” says Chirrey at Abbey National Asset Managers, “the trader must execute at competitive and attractive levels. If a trader cannot step up to the plate, then I am not going to hold it against him. Generally, they will make a price, but I would rather have an analyst who is outspoken regardless of what the trading book is saying.”

Making sure that the traders and researchers are all singing from the same hymn sheet is an area that some banks still need to improve on, says Chirrey. “Quite often traders have a totally different view from the analysts. Where they do take more notice is where there are negative credit stories or events. On a longer-term view, the analysts may have some fundamental concerns on a credit and the trader may take note and will not step up to the plate if they are asked to. They seem to listen to their analysts far more from a defensive stance.”

According to some bankers, the move to closer integration has taken place against the backdrop of a shift in power between the trading and research desks. One credit strategist says that in the past there was greater pressure placed on research to put a positive spin on trading positions, whereas today research is more in the driving seat. “Traders these days are not really allowed to put on a big position without speaking to research, and research are under no obligation to sell a position that a trader has picked up off his own back. There are instances, going back several years, where traders would come round saying, we have picked up u30 million of this – can you do something with it? It is a different relationship today.”

BNP’s Deutsch says the market is too transparent for that to happen now – it is obvious when research is trying to sell a credit to help the traders. But he does admit that the situation is not perfect. “Ideally, research is part of a three-way partnership with sales and trading to serve clients. The Eurobond market has not traditionally been a credit market, so traders and sales in many shops are not accustomed to having close relationships with research. It has taken a while for that to develop. Here we have put in place a daily discussion with the traders of our view of what is happening, where we see the market moving, and where the opportunities lie.”

“Most of the traders come from a quasi-sovereign, high credit-quality background,” he adds, “and sometimes it can take a while to catch on to the market and make that transition from the extremely high-grade to the corporate arena.”

Even with the best efforts at integration, the conflicts of interest that can arise between trading/sales and research should not be underestimated, as the following anecdote proves. One investor describes how an asset management arm recently lost a client because the research team at the affiliated investment bank had written a negative piece.

“We are part of the same group,” says Deutsch, “but we don’t have anything to do with the investment banking unit. But the client rang us up and said, you have written damaging things about us, we won’t do business with you. So you have a chain reaction from something negative that is written about a corporate credit that could sour any good relationship with a client.”

According to Emmanuel Weyd, head of credit research at JPMorgan, the advantages of integrated trading and research can be especially evident in the crossover market. The bank covers around 25 crossover credits, following the merger of its high-grade and high-yield research teams.

“You can provide excellent research,” he says, “but that can be undermined if you cannot provide liquidity and execute trades. Traders will not make a market in a bond if they do not have confidence in their research team. We need to have this partnership with trading in order to do this analysis.”

Adds Weyd: “For each of these names, we include complete projections (with various assumptions), an analysis of the entire group’s capital structure and detailed research on the company’s indentures. The research effort is combined with strong commitment on the trading side, where I would say JPMorgan is among the best providers of liquidity on these crossover names. Our research clearly benefits from this type of integrated effort. We can incorporate some very important technical factors into our relative value analysis, and our customers can immediately execute the trades we recommend on various names that are usually regarded as illiquid.”

Weyd says that input on market technicals from the trading side is a major advantage of an integrated approach. “You need constantly to be talking with traders to get this information,” he says.

Gronquist at Morgan Stanley agrees that technicals are an important area of input from the trading side. “No matter how aligned the views of trading and research may be on a given credit, it is up to the trader to assess the technical point of view. If they are trying to position something, then at the end of the day the trader has that call since he or she is taking the risk position.”

JPMorgan’s Weyd says that integration is important not only on the cash side – joined-up thinking between analysts and credit derivatives traders is important too. “You need that partnership not just with the cash trader but the derivatives trader, so you can understand exactly what the flows are on a name.”

Credit derivatives are becoming more liquid, adds Morgan Stanley’s Gronquist, though that is relative, according to one fund manager. Although the market is maturing, credit derivatives remain expensive to trade. “With derivatives you can access names you cannot in the cash market, leading to greater diversity,” she says. “Derivatives have added to the liquidity of the corporate market and the ability to undertake interesting trades. The standardisation of documentation has greatly improved the transparency of the market. We envisage the development of a true derivatives yield curve in the future. On the strategy side, we are trying to demystify the market.”

Credit derivatives are a potentially powerful engine for pumping greater liquidity into the credit markets, but with the markets on the back foot, the contrast between the wealth of ideas generated through research, both here and in the cash markets, and the hit-and-miss affair of executing trades, is clear. For banks seeking a dominant position in the European credit market, one conclusion is that the ability to commit capital to customer trading will be a key battleground.