Meeting in the middle

The equity and corporate bonds markets are more in step than ever before, prompting investment banks to merge equity and debt resources. Lisa Cooper asks whether thephenomenon is just a short-term cyclical shift or a more profound structural adjustment.

On July 22, the Dow Jones ended the day below 8,000 for the first time since October 1998. On the same day, the spread between US corporate bonds and Treasuries widened noticeably.

The following day, as the Dow fell further, spreads widened again. A correlation between the equity and credit markets has been growing stronger on both sides of the Atlantic throughout 2002. And similar comparisons can be made with European and UK equity indices and the relevant corporate bond spreads. There is a clear case of cause and effect here, but is it always the equity market driving the credit market?

Steve Dulake, credit strategist at Morgan Stanley in London, says: “There is lots of evidence to suggest that equity markets lead credit markets. Credit portfolio managers can draw information from equity markets to help them make better decisions.”

And the widespread use of Merton-based credit risk models – KMV for example – which predict corporate default by tracking equity market volatility, is also increasing the impact of share prices on credit.

While many asset managers are not employing KMV itself, they are generally using some derivation of the idea. Tim Webb, Barclays Global Investors’ head of credit investment in London, says: “We’re using any signals we can to help us pick up on credit events. And certainly, in some cases equity market volatility can be an earlier sign of problems within a company than we see in the credit markets.”

Regardless of the exact mechanics behind the correlation, the link is clear. As Simon Surtees, telecoms analyst at Bear Stearns, points out: “If the equity markets think the world is about to end you’d be flying in the face of the market to start buying bonds. Falling equity markets are making people feel less confident about the outlook for these companies.”

But what is interesting about the current credit and equity harmony is that it is not always the equity market leading corporate bonds. “There are times when the corporate bond market tail is wagging the equity market dog, for example France Télécom,” says Surtees. FT’s €65 billion debt burden is clearly the most important factor facing the company. And with no obvious growth prospects for the company, what the corporate bond markets charge France Télécom for capital is going to remain critical.

In a biweekly credit market strategy letter on July 22, Hervé Guez, consumers analyst at Crédit Agricole Indosuez in Paris, highlights three instances where the credit market has been ahead of the game. He singles out three French companies – Casino, LMVH and Pinault Printemps Redoute (PPR) – as examples of equity investors only now focusing on issues that have troubled credit markets for some time. “They [Casino, LVMH and PPR] are all blue chips and all are triple-B rated because of their relatively leveraged financial structures and because they are controlled by financial holding companies that are miserly in giving out financial information.”

“Furthermore,” he adds, “these companies have conducted aggressive acquisition policies and their management gives the impression, rightly or wrongly, that it has ‘massaged’ the accounts – while remaining in line with the accounting regulations in force, of course – to present them in the most advantageous light.”

Guez adds: “These problems, well known to bond investors, have in the current climate caused sharp falls in these stocks.” And predictably enough that has caused spreads on the three companies’ bonds to widen.

The new trend for corporate bond markets to lead their larger equity cousins is not peculiar to Europe. “In the US, the credit market is right now probably more important than the equity market,” says Percival Stanion, director of the strategic policy group at Baring Asset Management in London. “Equity investors are looking more at the corporate bond market than vice versa because it tells equity investors what the cost of capital is. If a company is highly geared and it has an increase in its cost of borrowing, that has a highly geared effect on profits,” he says.

“So an issue like a potential rating downgrade can have an enormous effect on the equity. Not only can it increase the cost of borrowing, it can even mean that a company is unable to borrow at all,” he adds.

According to Stanion of Baring Asset Management: “Because what happens on the credit side can now have a strong impact on the equity side, we have a member of our credit team present whenever we have our weekly equity strategy meeting.”

This is not unique to Baring; the opinion of credit investors and analysts is becoming much more sought-after. This year, Morgan Stanley took a credit strategist, Neil McLeish, to its annual event for European equity investors at Eden Roc for the first time. “I was pleasantly surprised that credit was identified as one of the areas that many participants wanted to cover,” says McLeish.

This a far cry from the 1990s when, in the words of Gary Jenkins, head of credit research at Barclays Capital in London, “equity analysts barely knew what a credit rating was. The equity analysts looked at their market and the credit analysts looked at theirs, and never the twain shall meet.”

Now that the twain have clearly met, the question is whether the change is structural or cyclical. Once share prices pick up, debt levels become more manageable and companies are once again able to raise funds via the equity markets, will credit issues be returned to the periphery for equity investors?

McLeish at Morgan Stanley says: “The greater integration is both cyclical and structural. It’s cyclical in that leverage levels are high, defaults are high and debt is important for all investors. So if corporate debt levels go down over the next few years then interest will fall. But, there is a structural element: the increased tradability of a company’s capital structure. Ten years ago you couldn’t trade the debt part as easily.”

“So in five years’ time credit will still be more important than it was five years ago – when it was nowhere. It might have fallen off somewhat but it will not disappear completely,” he adds.

Stanion at Baring agrees: “There has been a structural shift because nowadays credit is provided by the corporate bond markets rather than the banks. That means the cost companies pay for borrowing is determined by the credit markets.” This is true not only in Europe where the credit markets have only developed in the last few years but also in the US. “In the US the corporate debt market was tiny in the provision of credit compared with banks, now it is hugely important,” he says.

This is a trend that many expect to continue. Roger Appleyard, telecoms analyst at ABN Amro, says: “The corporate bond markets are becoming deeper and more important as banks increase the amount they charge for loans. So we expect even smaller companies to be forced into the bond markets.”

The growing importance of the corporate bond markets in the provision of lending has also created a shift at the macroeconomic level, says Stanion. “If the Fed reduces interest rates then it no longer necessarily leads to a reduction in the interest bill for corporates. This year the Fed has reduced interest rates by 475bp but the interest rates on corporate debt have increased,” he says.

“There is now a dislocation between the way monetary policy is transmitted to the economy, which means credit has become important in our view on all other asset classes,” he adds.
For all the structural changes taking place, credit is enjoying a level of attention that will not last for ever. As Toby Nangle, high-yield fund manager at Baring, says: “If all goes well and the earnings and equity markets bounce back, then of course the equity markets will forget about debt levels. They will not go back to not caring at all because creditworthiness is generally lower, but it will be less important.”

The reason credit is now so crucial is, ironically, thanks to the way it was ignored during the late 1990s equity bubble. Richard Davidson, equity strategist at Morgan Stanley in London, says: “What we went through was perhaps the biggest bubble in 70 years. It is usually only in the latter stages of a bull market that people ignore the risk and so ignore the credit market.”

The situation was compounded by corporate bond markets continuing to lend based on equities that remained overvalued. Mark Tinker, London-based head of debt and equity strategy at Commerzbank, says: “As the equity market bubble was bursting, the debt markets were still lending like crazy. Companies were borrowing on the basis of inflated equity market valuations, rather than on their ability to service debt through cashflow.”

But, while the equity markets may in time forget the credit concerns currently troubling them, the same may also be true the other way round, with credit investors again beginning to ignore equity valuations. “If equity markets flat-line for five years we won’t be looking at them in anything like the same depth and detail, as they won’t really have an impact. We will look at the economy and what that is telling us about credit quality,” says Barclays Capital’s Jenkins.

But, he adds, for the time being “you could put together one research note for both [equity and debt] and the only difference would be that the equity analyst has a different front and back page from the credit analyst. The fundamental analysis is the same; only the conclusions you draw and how it impacts your market will differ.”

With this in mind, investment banks have gone to varying lengths to benefit from the greater convergence by combining equity and debt. The most recent to have done so are Morgan Stanley and Goldman Sachs. In July, Morgan announced it was forming a single capital markets group and in August Goldmans said it was “actively considering” merging the two. Dresdner Kleinwort Wasserstein announced a similar merger in April and Commerzbank, which had already linked the two, has begun releasing joint debt and equity research.

However, there is no consensus on how far the integration should go. At DrKW, debt and equity have only been brought together physically in three areas – research, short-term products and derivatives – whereas Morgan Stanley has merged debt, equity and leveraged finance into one global capital markets division, with debt and equity staff sitting together.

And even banks that are not actually merging their debt and equity divisions are trying to strengthen the ties between the two. ABN Amro has coined the term “dequity” for its process of bringing the debt and equity analysts closer together, which began two years ago. But there are numerous critics who dismiss the process as a cost-cutting exercise dressed up as a response to the changing market.

There is clearly an argument in favour of credit and equity analysts cooperating with one another: they are, after all, looking at the same company, although each from a different perspective.

And according to Tinker at Commerzbank, covering both equity and debt has forced Commerzbank’s strategists to have a more rounded understanding of the companies. A lack of understanding of both sides of a company’s balance sheet was, after all, what led to the equity bubble in the first place. Robert Lister, head of capital markets research – equity and debt – at Dresdner Kleinwort Wasserstein in London, says: “The equity bubble stemmed from equity analysts and investors not understanding the capital consequences of growth. They had only been concentrating on the revenue.” Input from credit analysts has helped them gain a better overview of the companies.

Julia Peach, head of research at ABN Amro in London, says that for the credit analysts and investors the key benefit of closer ties with equity researchers has been the ability to take advantage of their greater depth of coverage. “The equity analysts sometimes cover only around five names each, while we can be required to cover 50 to 100. So, for example, we’ve done joint investor calls with our equity counterparts in which we provide the product expertise and fixed-income market perspective, while they provide very detailed information on the companies,” says Peach.

Nevertheless, there are doubts about how far this process can be taken. Monima Siddique, managing director of the financial research head-hunters City Analytics, says: “There are two sets of fund managers – those that buy equity and those that buy bonds. If you produce one report for everyone it could be the size of a phone directory and might simply end up in the bin because people don’t tend to pass things around.”

Despite advocating greater company cooperation in research, Peach is in turn dubious about the benefits of merging the trading, distribution and origination processes, saying that the debt and equity businesses are “completely different animals”.

Not only are there doubts about the usefulness of integration but there are also concerns about potential for conflicts of interest. Tinker points out that what benefits one part of an institution – or one set of investors – may actually harm another. “The guys in the credit market say France Télécom must have a rights issue, because that would benefit them as credit investors. But the equity investors actually own the business, and they don’t see why they should have to sell off physical assets or shares in the company at rock-bottom prices just to keep the credit people happy.”

Notwithstanding, Morgan Stanley has tried to merge its equity and debt capital markets teams – but not research – apparently driven by primary-market client demands for a single point of contact for all their financing needs.

In defence of the shift, Catherine Gronquist, Morgan Stanley’s head of credit research in London, asks: “Does it make sense for two teams of capital markets guys to talk to a company?”
But Jenkins is more cynical. “The putting-together of the various product groups must give an opportunity to review headcount. While a good capital markets professional should be able to learn new things, there is no substitute for 15 years of debt capital markets experience.”

Just as the debt and equity markets are likely to diverge when economic prospects pick up and the natural order is restored, so the newly formed ‘dequity’ banking teams may well find themselves undergoing a hasty demerger.