Acceptance Speech for Martin S. Fridson

Remarks by Martin S. Fridson, Merrill Lynch Chief High Yield Strategist at the The Hall of Fame of the Fixed Income Analysts Society, Inc.

November 1, 2000I cannot conceive of any higher honor than entering the Fixed Income Analysts Society Hall of Fame in the same year as Harold Goldberg, who was so generous to me with his time and his encouragement. Hal had and abundance of that valuable but all-too-rare quality of patience. And it’s also a thrill to be inducted along with Dan Fuss, one of the most astute individuals in the money management business. But I’m especially happy to have an opportunity to say a few words about where our profession is heading. I mean that not only in a broad, philosophical sense, but also in terms of the present market upheavals. Naturally, I’ll frame my remarks with a set of initials. This is a time-tested formula in our field. For example, you’ve probably heard of the Three C’s of Credit: CHARACTER, CAPACITY, and CAPITAL. It’s the sort of thing that makes you sound a lot more systematic than you probably are in reality. So here are the Three P’s of fixed income analysis:

• PATHS
• PERSPECTIVE
• PRINCIPLES

Paths

The first P is Paths, as in "off the beaten." To my way of thinking, one of the most attractive aspects of fixed income analysis has always been the opportunity to do something distinctive. Investors benefit from a variety of approaches and opinions, rather than a lot of me-too products. I take pride in the fact that while investors may agree with our research or not, they have to concede that it looks different from the competition’s.

For example, I believe that Merrill Lynch is currently the only firm that produces a periodical of basic research in high yield, where we develop empirical methods that we then apply in our weekly commentary. This publication, Extra Credit, along with its predecessor, High Performance, has been a vehicle for many off-the-beaten-path items. For example, we’ve conscientiously covered the careers of thoroughbreds with names linked to our market sector—Subordinated Debt, Junk Bond King, Doubtful Debt, and this year’s Kentucky Derby entrant, High Yield.

In 1985, we published a research report on Warner Communications that featured a photograph of a vocalist who was just beginning to achieve stardom—Madonna. We scooped Time and Newsweek, both of which ran her picture on their covers a few weeks later. This all came about when I asked our media analyst to get a couple of publicity photos from Warner. The company dragged its feet and then just minutes before our deadline provided some slides. I couldn’t completely make out the image, but it appeared that Madonna was wearing clothes, so I gave the green light to run the photo. When the publication appeared, it turned out that she was actually wearing underwear--only. That raised some eyebrows at Morgan Stanley, let me tell you. But again, it was distinctive research, just as our practice of running obituaries is.

After the default of a pig farm operator in 1996, we boldly ventured where few had dared to go before, right into the burgeoning field of hog waste. Each year, we run an update of technological advances in managing the environmental impact of swine slurry. For investors who have not yet sunk their teeth into this matter, it’s time to wake up and smell the coffee…if possible.
Obviously, we like to keep our research lively. But we take an extremely serious approach to analysis. A key element is our insistence on one hundred percent transparency. In every other branch of science, researchers have to enable others to reproduce their results. I see no reason why Wall Street strategists should not be held to the same standard.

We also follow the rule that in order to forecast the future, your first have to demonstrate that you can explain the past. Financial market pundits frequently skip this step.

Perspective

The second P is for "perspective". The high yield bond market is currently in its deepest slump since the Great Debacle of 1989-1990. Experience suggests that such episodes create extraordinary opportunities. But don’t assume that investors have learned that lesson and will soon act upon it. In all my study of stocks and bonds, I have found no evidence of learning in the financial markets.

Perspective is essential at this juncture. Nobody disputes that current conditions are extraordinarily difficult. In fact, one portfolio manager told me that several of his issues are trading at dollar prices in the twenties. So he’s hoping to have a few defaults, because I’ve told him that on average, defaulted bonds trade around 40.
But it’s so easy to lose perspective. During the 1980s, the annual issuance of high yield bonds grew from one billion dollars 33 billion dollars. The engine of that growth was the leveraged buyout revolution. Then came the bust. The default rate skyrocketed. The story went around that "LBO" was an acronym for "Let’s Bankrupt Ourselves." Issuance receded all the way back to $1 billion in 1990.

At that point, the managers of high yield activities at Merrill Lynch got together to decide whether it made sense to remain in the business. I went out and collected data on the savings rate, growth in income, and mutual fund assets. From my analysis, I concluded that new-issue volume would one day return to as much as $5 billion, or possibly even $10 billion a year. That made me the bull of the group, by a wide margin. The mistake I made was putting that analysis into print, where people could see it. When high yield issuance reached a new peak of $140 billion in 1998, I made a resolution. In the future, I would never sell short the inherent wisdom of investors.

I think it’s a safe bet that we’ll see the 1991 comeback story repeated over the next few years, although with less violent swings. Unless I’m gravely mistaken, the high yield index’s spread-over-Treasuries will not remain 300 basis points wider than its historical average forever. New issuance, which may total only $60 billion this year, should eventually return to its 1998 high and surpass it. And at some point, money will flow back into the high yield funds, because investors have shown an enduring affection for the asset class.

What will it take to turn the market around? The good news is that we don’t have to rely on mysterious forces such as the fabled Market Psychology. This term is undefined, in fact undefinable, i.e., meaningless. We cannot observe Market Psychology.

So, let’s instead look at influences on the high yield sector’s risk premium that can be observed and quantified. These factors make up the empirically grounded Garman model of the high yield spread-versus-Treasuries, a cornerstone of our research. Based on the major recoveries of 1991 and late 1998, we can pinpoint the conditions that coincided with the rise in prices.

I’m happy to report that in both 1991 and 1998, the rebound began before default rates started to decline. Therefore, the highly publicized debate about how far default rates will rise in this cycle is rather beside the point. The Garman model indicates that present prices already discount a more dire default outlook than the most pessimistic authorities project.

History strongly suggests that the resurgence in high yield bond prices will occur when the Treasury yield curve, from three months to ten years, turns positive and steepens dramatically. That will encourage investors to venture out into longer-dated instruments. A steeper yield curve will also increase the amount of ambient speculative capital in the market and encourage dealers to expand their bond inventories.

Nobody,not even Alan Greenspan, knows when short-term rates will come down, causing the yield curve to steepen. But it may happen sooner than we suspect, given the accumulating signs of economic slowdown. And when the yield curve steepens, the impact will probably be profound. Remember that in 1991, the Merrill Lynch High Yield Master II Index produced a total return of 39%. And during the short, explosive recovery of 1998, from the middle of October to the end of November, the index returned 7.17%, which annualizes to 73%. You shouldn’t necessarily count on matching those numbers in the next upturn. But I do believe that you’ll be rewarded handsomely for buying at today’s levels and being patient.

Principles

Finally, I get to the third and most important P. P is for Principles. It would be presumptuous of me to lecture a room full of adults on morality. In some cases, it would also be futile, and you know who you are. But during my quarter of a century in the bond business, a few guidelines have kept me out of trouble, so I pass them along for your potential benefit.

The first principle is that we serve our shareholders best by serving our customers first. Idealism aside, establishing credibility with investors over a long period can create monumental franchise value. Admittedly, there’s a quicker payback on picking off investors, but after a while, you run out of victims. As my friend Joe Colquhoun pointed out when I was starting out as a corporate bond trader in 1976, it’s not a good career move to make your livelihood dependent on dumb investors. Over time, they’ll probably get eliminated from the market in a Darwinian manner. Second, in deciding whether to advocate an investment idea, I’ve discovered an infallible screening method. I ask myself, "Would I do this with my own money?" Not with a client’s money, but with my own. If the idea fails that test, I know I’ll just embarrass myself by trying to talk it up to investors.

On a related point, we should always remember that our job is to be analysts, not advocates. Efforts to promote an asset class or some newfangled derivative are best left to the marketing department. Research people discredit themselves when they become cheerleaders.

Another invaluable principle for me has been something that Ray Kroc of McDonald’s said: "We take the hamburger business more seriously than anyone else". Fixed income analysis is a lot like hamburgers. You can succeed by taking it more seriously than anyone else. We do not achieve excellence by viewing an analyst’s position as a mere stepping stone to a job in investment banking or as a trial we have to endure until we get our shot at running the portfolio.

Of course, many of us do hope to do other things at later points in our careers. But as long as the task at hand is fixed income analysis, we owe it to those who rely on our judgment to take the job very, very seriously. Taking research seriously means believing that there’s a best answer to the question at hand and being determined to find it, no matter how much sweat it takes. Let me add one more thought in the area of principles, I keep in my office, where I can see them as I work, the words that John C. Stennis spoke when he ran for the United States Senate in 1947:

I want to plow a straight furrow right down to the end of my row. This agricultural metaphor may not mean a lot to many of you in the audience. Even when I worked on a farm, in the 1960s, the plowing was all mechanized. But when Stennis’s father plowed the Mississippi soil with a mule, he needed an extremely firm hand to make the furrows straight. It’s much the same for fixed income analysts today. We have to resist many pressures to veer off to one side or the other, to make our analysis agree with somebody else’s predetermined conclusion. There’s a lot of temptation to make our analysis agree with somebody else’s predetermined conclusion.

I’ll let others judge how well I’ve handled my plow. But I’ve been fortunate to have a big streak of stubbornness. Even though I was born in Michigan, there’s a little bit of that Mississippi mule in me. It’s given me pleasure, from time to time, to come up with research findings that I KNEW would create consternation within my own firm. And I haven’t minded if our CUSTOMERS occasionally found my conclusions inconvenient. I just wanted them to feel confident that I’d come by those conclusions honestly.

Experience has taught me that if you do thorough, unbiased work, you’re going to upset somebody with every research report you write often for reasons you can’t possibly foresee. So there’s nothing to do but plow straight ahead, right down to the end of the row.

Whenever I’ve felt uncertain about how to proceed, I’ve tried to think far into the future. One day, I’ll have to look back and ask myself, "What did my life stand for?" Every one of us will have to ask that question. For me, it won’t be good enough to say, "I was the voice of the received wisdom. I repeated what everyone already believed, without bothering to test it against the facts. I kept silent whenever I reached an unpopular conclusion. Speaking to my children, who are here this evening, and to all of my fellow fixed income analysts, I hope that answer will never be good enough for you, either.

o there you have the three P’s, Paths, Perspectives, and Principles. If you put them all together, they lead to that one very important objective that starts with the same letter, Performance.

In conclusion, being named to the FIASI Hall of Fame is a responsibility, as well as an honor. I will always strive to bring credit to those who have bestowed it on me. In addition to thanking the leadership of the Society, I’d like to express my gratitude to each of my friends, colleagues, and family members in the audience. Your presence has helped to make this one of the proudest moments of my life.