By Satish Pulle
2012 was a very strong year for credit; especially so for financials. With the New Year getting off to a reasonably positive start on a duration hedged basis, it is only natural that our investors are asking where the attractive opportunities are, and what will drive volatility.
We believe bonds issued by financial institutions offer attractive opportunities for earning yield with low duration risk. For idiosyncratic investments we expect volatility to come back, so it is important to reduce risk exposures in a strong market and increase them in a weak market.
We see many idiosyncratic opportunities as well. For example, KBC issued a coco at 8%, which we find attractive as the net loss required to write off the instrument is €5.6bn, which is substantial considering KBC lost €5bn in their worst ever two year period 2008-09, and current net income is €1.5bn per annum. By comparison, we avoided SNS subordinated securities as it was very unclear how the group could conceivably raise a very large amount of new capital without government intervention.
What will likely drive volatility?
Weak growth: We expect economic growth in Europe to disappoint, as credit demand and supply are still very constrained, particularly in Italy and Spain. Uncertain banks are unwilling to lend. Cautious consumers, small businesses and mid-sized corporates are not confident enough to borrow to expand. If economic growth disappoints as we expect, questions will again be asked about the right mix of government austerity and growth plans, and about the sustainability of rising sovereign debt levels.
Messy politics: Reform is hardest in a time of economic contraction – Italy and Spain are more likely to go slow on this front. Potential post-election troubles in Italy, and weak Spanish growth, are both likely to weaken sentiment towards their government bonds over the next few months. If Spanish and Italian bond yields rise again, so will financial sector bond yields. In addition, we would not be surprised to see strong challenges to the political will of the Greek government as it seeks to implement unpopular reforms passed in Q412.
On-off ECB support: The go slow agenda of politicians in Spain and Italy is likely to clash with the need for the ECB to see genuine reform. One key lever the ECB can use to pressurise politicians to implement reform is simply the size of their balance sheet. If the ECB allows substantial additional repayments of LTRO funds, credit and peripheral government bond markets are likely to weaken. While peripheral bond yields now price in OMT, kick- starting the programme almost certainly requires a period of rising yields and market stress.
Ratings downgrades: Senior and subordinated bank debt downgrades are likely, particularly if Spain is downgraded to sub-investment grade, which could be driven by Q1 GDP disappointment and slow progress on reforms. Another reason could be the Dutch government’s decision to expropriate subordinated bonds in SNS Bank and SNS Real Group, as this marks much harsher treatment of such bonds for unviable institutions.
Satish Pulle is lead portfolio manager of the ECM Financials fund, ECM.
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