New York – Recent academic articles examine sell-side debt research, primarily from the perspective of how sell-side debt research tends to complement credit rating research. The more interesting comparison is with equity research, which plays a more prominent role. Why is sell-side debt research a wall-flower compared to equity research? The answers are partly historical and partly economic.
Academics have recently taken an interest in sell-side debt research, particularly as it relates to credit rating research. Johnston, Markov and Ramnath examine what factors determine whether debt gets covered by the sell-side, finding that coverage centers on firms with a higher probability of financial distress, lower market-to-book ratios, larger debt and higher leverage. Sell-side research is highly focused on predicting credit rating downgrades, which move market prices.
Kolanski finds the study by Johnston, Markov and Ramnath as evidence of ratings agencies market power and combines it with another study which suggests that ratings agencies abuse their market power by offering a poor quality product.
Our goal here isn’t to beat up on the ratings agencies since there are plenty doing that right now, both in Washington and the courts. Rather, the interest is in how sell-side research differs from its equity counterpart, and what might be the reasons for this.
Debt vs. Equity
Johnston, Markov and Ramnath hypothesized that the determinants of debt coverage would be similar to those of equity coverage. An earlier study of what factors influence equity coverage found that company size (easier to trade), return volatility (price impact of new information greater), the number of business lines (harder to analyze and thus less likely to be covered), and the correlation between company return and market return (the more beta-like the stock, the easier to analyze and thus more likely to be followed). Johnston et al. thought that these factors would also impact debt research coverage, but they did not.
Instead, they found that sell-side debt research zeroes in on firms that are candidates for ratings downgrades, and that reports issued by debt analysts tend to precede ratings downgrades. Debt reports are most common in the 120 day period preceding rating downgrades.
Sell-side debt research is sparser than equity research. The total number of companies covered by debt analysts was 1,217 whereas equity analysts covered 10,612 firms (this was over a five year period from 1999 to 2004). The maximum number of debt reports any firm received during that period was 38 reports whereas for equity research the maximum was 91 reports (!).
There is a historical reason for the anemic nature of sell-side debt research, which relates to the rise of the ratings agencies. It goes back to the default of Penn Central in 1970, which at the time was by far the largest corporate debt default, causing huge losses. Many sources, including the rating agencies, cite this event as seminal to the influence of credit ratings. For example, Fed economist Thomas Hahn states, “Since 1970, when the Penn Central Transportation Co. defaulted with $82 million of commercial paper outstanding, almost all commercial paper has carried ratings from one or more rating agency.” This was the period when ratings agencies switched from subscription models to issuer paid models.
Not coincidently, the Penn Central bankruptcy represented a major crisis for Goldman Sachs. Most of the defaulted Penn Central commercial paper had been issued by Goldman, and the resulting lawsuits threatened the partnership capital and life of the firm.
The back story (told informally within the ratings agencies) is that Goldman was instrumental in the rating agencies moving to issuer paid business models. Goldman no longer wanted the liability associated with credit research, preferring to outsource it to the ratings agencies. To upgrade the staff of the sleepy ratings agencies to produce the kind of research required, they had to generate higher fees. Goldman, and other investment banks, brought the deals to the ratings agencies, facilitating the adoption of the new business model.
There are also economic reasons for the differences between sell-side debt research and equity research. Although it is technically feasible to soft dollar fixed income trading, it is not common. The main reason is that there is no explicit commission for fixed income trading, since the dealer is paid through the spread between bid and ask.
Sell-side debt research is primarily paid by directing trades to the broker that provides the service. Since it is not always clear whether the trade resulted from execution capabilities or from research, the resources devoted to research are lean and very integrated with trading. Often, the debt analysts sit on the trading desk. There is a very clear cost/benefit to providing the research, as Johnston et al. put it, “Overall, we find that the amount of sell-side debt research is related to the costs and benefits of providing that information.”
In contrast, equity research receives a subsidy from soft dollar commissions, which creates a glut of research. Perhaps sell-side debt research is a good proxy for what equity research would be like if 28(e) were ever abolished.
However, Washington is not wrestling with that issue right now. The more immediate problem is the rating agencies, and their issuer paid model. As distasteful as regulators find it, the issuer paid model is very convenient for the buy-side since it reduces their cost of research. It is also convenient for the investment banks because it reduces the liability associated with their debt issuance. Given the implicit backing of these two influential constituencies, any guesses on how quickly Washington will abolish issuer pay?
 “Sell Side Debt Analysts“, Rick Johnston, Stanmir Markov, Sundaresh Ramnath, February 15, 2008.
 “A tale of two intermediaries: A discussion of Johnston, Markov and Ramnath (2009), and Cheng and Neamtiu (2009)“, Adam C. Kolasinski, Journal of Accounting and Economics, November 2008.
Volume 11, Issues 2-3, July 1989, Pages 255-274.