Wachovia

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A migration is under way in the bond market, but the moves are emanating from points further south than Wall Street. Wachovia is pumping up its fixed-income operations, plucking credit experts from competing firms and inching its way up the league tables. The Charlotte, North Carolina-based commercial bank has spent the past decade building up its investment banking capabilities, and this year it’s making an ambitious claim on markets dominated by behemoths like Merrill Lynch and Morgan Stanley.

So far this year, the country’s fourth-largest bank has added 40 new traders, originators and sales people to its fixed-income workforce of 1,500, with plans to add 100 to 125 more. In the first quarter, the group doubled the share of high-grade corporate bonds it underwrote from the previous year, breaking the top 10 ranks for the first time ever. Underscoring its commitment to the fixed-income expansion, Wachovia has just poured $13 million into enlarging the trading floor at its Charlotte headquarters.

Curtis Arledge, the 39-year-old head of Wachovia’s fixed-income group who is overseeing the expansion, says he intends to grow revenues 10% this year to $2.3 billion—driven mainly by growth in the credit products area, particularly investment grade and leveraged finance—despite the anticipated decline in overall fixed-income activity as interest rates rise.

“Our platform still has lots of room for growth,” he says. “We obviously are aware of the fact that the market dynamics are going to be less positive than they’ve been in the high-grade business, so we’re adding [staff] at a rate which we think is in line with what the opportunity is.”

In fact, he argues that Wachovia would be expanding many times over if market conditions were more encouraging to borrowers and investors, who drove a massive bond rally over the past few years.

Analysts are drawing mixed conclusions about Wachovia’s evolution. “Clearly they want to become a more meaningful player to their corporate customers. That is going to require them to have access to and capability in fixed-income markets,” says Matt Burnell, banking analyst at Merrill Lynch. “Whether or not they are going to be able to compete in the long term with the bulge bracket investment banks, and firms like Citigroup and JPMorgan, remains to be seen.”

Humble origins

Wachovia, first and foremost a commercial bank, barely had an investment banking presence until a few years ago. In 2001, the year of its merger with First Union, when Wachovia became the country’s fourth largest bank, the fixed-income effort was scattered across various divisions, generating annual revenue of $800 million.

“We had lending relationships with a lot of corporations, we had assets we had financed through various conduits, we had all the pieces of the puzzle except for the structuring, trading and distribution end of the fixed-income business,” Arledge says.

Instead, Wachovia’s strength lay in its commercial banking business, and its relationships with medium-sized corporate borrowers who sometimes tapped its investment banking capabilities.

“We had a menu of corporate clients who were relatively infrequent issuers in the high-grade market, and because of that they sometimes traded at wider spreads to more on-the-run names,” Arledge says. Although these smaller deals didn’t generate the kind of fees usually paid by blue-chip borrowers, the higher spread they offered helped attract institutional investors looking for better returns. This access to investors, in turn, helped Wachovia attract more corporate borrowers.

As a commercial lender with a strong foothold in the real-estate market, Wachovia started out by building its corporate and investment banking capabilities around structured products in real estate. (Today, structured products are the main profit engine in fixed income, targeted to generate $800 million in profits in 2004.)

In time, Wachovia expanded its expertise to other niche markets, where competition from the Wall Street giants wasn’t stifling, and focused its efforts on the easily accessible medium-sized companies that it understood best.

“In sectors like the REIT [real-estate investment trust] industry, the energy and power space, and the insurance industry, we really became much more relevant both to corporate clients and institutional investors by bringing products that were going to be index-beating performers,” says Arledge.

Today, some of Wachovia’s biggest customers come from those sectors, and include power concern Dominion Resources and Weingarten Realty Investors, a Houston-based REIT which owns and runs shopping malls and industrial sites. Arledge argues that this strategy of specializing in niche markets where the commercial bank is already strong, and gradually convincing borrowers to buy more and more credit products from Wachovia, has been crucial to growth. But analysts say other universal banks, like Bank of America, have followed the same strategy in the past decade with mixed success.

“You simply take customers who are doing traditional banking business with you, and you shift them off the balance sheet by raising money for them in the open market. That allows you to move up the league tables and increase your growth in investment banking,” says Richard Bove, analyst at Hoefer & Arnett. But this “clearly comes at a cost to the bank, because your traditional lending business is not rising if you’re taking the business and shifting it into investment banking”.

Still, Wachovia’s approach so far seems to be working on the bottom line. Net income at the bank rose 22% in the first quarter to a record $1.25 billion, with corporate and investment bank profits climbing 62% on the year to $454 million. Fixed income makes up about 11% of total bank revenues, and while some of this growth came from rock-bottom interest rates and a stronger economy, analysts say some of it also resulted from improved fixed-income operations.

Unification

To harness this momentum, Wachovia recently reorganized some of its corporate and investment banking group by bringing all of its equity and debt operations under one capital markets roof, headed by former fixed-income chief Ben Williams.

Similar to its policy of meshing services offered to clients on the commercial banking side with those offered in the investment bank, this decision was intended to bring the two platforms closer together, “so if there’s a fantastic relationship in our equity or syndicated loan products business, we want to bring about the ability to easily expand that relationship to the fixed-income side,” says Arledge.

As part of this realignment, Arledge was promoted to head of fixed income in William’s place, and any credit-related desks which previously might have fallen under other managers now report to him.

Arledge now oversees more than 1,500 employees scattered across the US, Europe and Asia, with about 80% of staff located in Charlotte.

The credit products division headed by Julie Bouhuys is the largest in fixed income, with about 40% of revenues, and includes investment grade, leveraged finance and portfolio management. The structured product group run by Tom Wickwire includes commercial real estate, asset-backed securities and collateralized debt obligations (CDOs), and accounts for about 35% of revenue. The global rates business, run by Thold Gill, brings in 25%. Each of these units has its own origination, sales, research and trading desks.

Of the 150 new positions in the fixed-income group across the US, Europe and Asia, the bulk will be created in investment grade, high yield and loan syndication, and in the structured products sales departments. Arledge recently hired a new head of Asian sales based in Hong Kong, and is expanding the sales force in London.

Arledge emphasizes that although salespeople might be assigned to different desks, their aim is to combine efforts and approach clients with a coordinated message. “When we go in and pitch [deals to clients], we talk to them about financial solutions that might include a loan product, a bond product, a structured finance product, or it might include a combination of multiple products,” he says.

Arledge applies a certain scientific approach to running the business—maybe a hangover of his days studying science at Princeton. “That’s the way we think about our business,” he says, drawing a parallel between laboratory work and investment banking: “You send a signal into the system, you measure the output of that system, and you use what you learn from that to drive the next input into the system. So that your output constantly gets better.” By the same token, “we work with institutional investors all day long, we sell them products, we hear from them what they like, what they didn’t like. We tweak those things to get them the products that they need,” he says.

Team-building

Although the structured products group has traditionally driven profits in Wachovia’s fixed-income division, most of the current expansion is taking place in the investment-grade unit, run by Bank of America’s former head of high grade, Jim Kelligrew.

One of Wachovia’s most important hires in the past year, Kelligrew spent 10 years at Bank of America building its debt syndication desk from scratch into one of the top 10 in the country. Since joining Wachovia in November, he has hired 15 executives and plans to add another five to 10, in addition to the 15-member emerging markets team he inherited when Wachovia set up a joint venture with Prudential.

“This is just the tip of the iceberg,” says Kelligrew, sounding confident that he can help Wachovia make a splash in a tough market. His aim is to increase investment-grade profits by 60% in 2004, partly by boosting income from sales and trading which currently only makes up a quarter of high-grade revenues. The remainder of revenues comes from new-issue fees, mainly investment-grade corporate bonds and preferred securities. Kelligrew also wants to start adding bigger companies to Wachovia’s client base of medium-sized firms, relying on his experience of building relationships with blue-chip clients at Bank of America.

But that may not be as easy as it sounds. Analysts say Wachovia has succeeded in gaining investment banking market share in some sectors by tapping relationships with its commercial banking customers but that it will have a harder time winning over large borrowers who provide Wall Street bankers with the vast majority of business.

Hoefer & Arnett’s Bove says Wachovia’s progress so far “doesn’t mean you can break into doing business with Fortune 100, or even Fortune 500, companies. It’s a different type of business. You’re doing asset-backed securities, you’re doing mortgage backeds, you’re doing equipment financing. That’s different from knocking on the door of one of the nation’s largest businesses and saying, we’re going to offer you something that Citigroup or Goldman Sachs or Lehman Brothers can’t offer you. I don’t think that’s going to happen.”

One area where relationships with large borrowers can make a big difference is in lead-management of corporate bond deals, and Kelligrew has his sights set on gaining market share there. He has already made some progress in that area: in the first quarter of 2004, Wachovia lead-managed twice as many high-grade corporate bonds as in the same period a year ago, increasing its slice of the pie to 3% and putting it into the ranks of top 10 underwriters.

Kelligrew says if he can translate some of Wachovia’s co-managing relationships—Wachovia currently helps place about 20% of all high-grade corporate bond deals—into lead-managements, he should be able to grow market share to 6–8% and earn a steady spot in the top 10. In 2003, Wachovia ranked fifteenth in the league tables with 75 high-grade corporate bonds worth $9.7 billion dollars, or 2% of the market share, according to Thomson Financial.

While Wachovia’s latest climb in the league tables has garnered a fair amount of attention in the press, Arledge insists that’s not where his focus lies. “League tables don’t tell the true story,” he says. “There are many things that we know how to do very well. But we don’t want to build a big infrastructure just so we can pound our chest and say we’re number two in something.”

There’s no question that last year’s deal with Prudential, which gave Wachovia one of the country’s largest retail distribution networks, helps in winning new-issuance business. “The Prudential joint venture has been a huge home run for the investment-grade debt business at Wachovia. If you look at the competitive advantage Wachovia has, we’re now only one of four or five firms who have that retail distribution angle,” says Kelligrew.

Wachovia Securities and Prudential created a joint business under the Wachovia name last summer, owned 62% by Wachovia and 38% by Prudential. It is the third-largest full-service retail brokerage in the country, and gives Wachovia corporate customers access to a much coveted investor base.

“If they can get it working right—and I don’t think that’s certain yet—it would be very positive,” says Bove. “Suffice it to say, Wachovia is one of the top three to five [retail brokers] in the nation, and that gives them a very powerful edge in the marketplace.” In the domain of preferred securities, for example, Wachovia ranks as one of the top lead underwriters by market share, which is partly a result of Wachovia’s access to retail buyers in that sector, according to Kelligrew.

In addition to investment grade, Wachovia also plans to expand in the loan syndication and high-yield business, which fall under the leveraged finance category. Arledge is currently hunting for a specialist who can head up that effort, and hopes Wachovia can become a “dominant player” in the sector.

Wachovia is also selectively beefing up product offerings to include services in emerging markets, liability management, ratings advisory, corporate bond repackagings, and secondary trading for privately placed debt.

Although Wachovia is expanding into new areas cautiously—like emerging markets—Arledge doesn’t want to lose sight of the firm’s core specialties. And it’s almost a point of pride with him that Wachovia lacks some obvious pieces of the fixed-income platform, for example Treasury trading for clients—although Wachovia does trade Treasuries for hedging purposes.

“When we set up our investment-grade business, we looked at what was happening in the commercial real-estate industry, and in the energy and power space specifically. And we decided that we would focus a lot of our effort in providing services to that clientele,” says Arledge. “Today we find ourselves in the place where we think [there] are three or four sectors where we should be really focusing our capital, both intellectual and economic. We’re not so big that some of the harder problems get lost because we’re busy trading two-year Treasuries all day long.”

Friendly rivalry

In the end, it remains to be seen if Arledge and his growing team of specialists can help Wachovia build a dominant fixed-income platform. With Bank of America just down the street, some argue that Wachovia is getting ready to challenge the country’s third largest bank as a leading corporate and investment banking player in the south.

Wachovia has hired about 20 former Bank of America executives in the past 18 months, but Arledge denies anything less than amicable is going on. “This is not a cross-town rivalry type of thing. We like to see Bank of America do well, and we think a lot of their platform and what they’ve accomplished,” says the North Carolina native, adding that Wachovia can hold its own against Bank of America in certain areas like commercial real estate and CDOs. “But there is not a rumble in the mix.”

Indeed, Wachovia is far from matching Bank of America’s $9 billion in annual corporate and investment banking revenues. And in the league tables of new debt issuance, Bank of America consistently ranks in the top 10 of lead-managers across a range of categories, while Wachovia rarely does.

Nevertheless, analysts seem to agree that Wachovia can deliver on its promises, with 15 out of 24 rating the bank a ‘buy’ or ‘strong buy’ according to Thomson/First Call. The main challenge for Wachovia’s fixed-income efforts this year is rising interest rates. With economists expecting the Federal Reserve to hike the overnight lending rate by August at the latest, corporate borrowing is expected to drop, putting a damper on many fixed-income activities.

“I think everybody’s fixed-income business will be hurt to some degree. The question is how can they offset that with greater levels of commercial and industrial lending” resulting from increased economic activity, says Burnell.

Arledge says he can handle it. “With the advent of the credit derivatives market, the fixed-income market is no longer just a bull fixed-income market. Clearly there are greater underwriting fees and market clients in other parts of the business when rates are low, but there are businesses we now run that will do better when rates rise,” he says.

Kelligrew argues that while business might be hurt initially when rates start to rise, institutional investors and retail investors will be willing to jump back in to take advantage of the higher returns that come with rising rates.

But what about the risk of expanding a business in the midst of a downturn? Arledge says he can offset any slowdown with his efforts to gain market share, pointing out that while new-issue volumes in the high-grade market dropped 28% in the first quarter of this year, Wachovia’s business jumped 140%. Plus, Wachovia’s fixed-income group, with 1,500 employees, is still significantly smaller than some of the competing firms, he says.

While he has no intention of growing his group to that size anytime soon, his eye is still on the big prize. “There’s been a big consolidation in our industry. We see a lot of players who have a large capital base becoming less competitive. And we are one of the up and comers,” says Arledge. “We’re increasingly going to become a force to be reckoned with, and an important provider of capital markets products to our clients.”

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