Credit Research – The Cornerstone of Investment Process
- December 4, 2020
Investment research assists investors in making better decisions throughout a market cycle. An investment process at its core involves laying out a set of guidelines that would ultimately govern an investor’s or financial advisor’s decision-making process. Investors need to drive the steps in an investment process, such as portfolio strategy, asset selection, weightage allocation, and ultimately, performance review. The process involves understanding an investor’s end goal, their risk appetite, and accordingly, research investment options. It aims to meet investment goals, such as generating a minimum targeted level of returns or outperforming specific market benchmarks, including key indices, while minimizing the risk inherent in investing. Accordingly, credit research can play a key role in minimizing risks.
The credit or fixed income market is by itself one of the largest class in terms of assets under management, exceeding several other asset classes, such as equities. The cornerstone of research in the credit market is to evaluate the relative safety of future cashflows (both coupons and principal repayment). Credit research of a particular company, or any debt issuing entity, entails the analysis of the company’s industry, business model, and historical financial statements to determine its credit worthiness and precedence. It further involves analyzing financial statements with focus on capital structure and using various financial modelling and techniques, such as trend and ratio analysis. Moreover, it involves preparing forecasts and conducting an in-depth analysis of cash flows to determine the company’s future repayment capacity. Furthermore, the credit research process extends to scrutinizing the management proficiency, bond covenants, debt collaterals, and other repayment sources.
Credit research, with a view of identifying potential risks, can give perspectives or insights into the investment target that may be overlooked by traditional equity research. Typically, equity research focuses on earnings and intrinsic valuation based on discounting future cash flows, without appropriately exploring the probability of occurrence of those cash flows. Consequently, the credit or fixed income market has historically gauged the change in market cycles much better than equity markets. A case in point is the yield spread between 2-year and 10-year US sovereign bonds, which has indicated every coming recession since 1955, when the spread turns negative.
Traditional equity research outfits may not necessarily develop credit research capabilities from the ground up. An external credit research agency can supplement traditional research tools in a cost-efficient manner. An expertly conducted credit research can add value in various ways to different sectors and security selections. Appropriately conducted credit research can help avoid investment traps that can skew portfolio returns. Moreover, in a competitive asset management industry, credit research would help maintain the edge in maximizing investment returns.