By Mark Wauton, head of credit, Aviva Investors
It has been five years since the credit crisis began, marking an abrupt halt to the perception of corporate bonds as safe yield-generating assets, as hitherto reliable companies defaulted or were downgraded into high yield.
Today, credit is trading relatively cheaply because investors have become more risk averse in response to the weak global economic outlook and continuing debt problems in the European periphery. This however ignores the fact that many companies have improved the quality of their balance sheets over this period by deleveraging, and this, combined with the fact that credit is priced well below its historical average, means that there are opportunities at a compelling entry point. In terms of credit, the financial sector is one that is generating particularly interesting investment opportunities. A number of banks have deleveraged and grown their deposit bases in the wake of the credit crisis, improving the quality of their balance sheets. There has been a widespread improvement in banks’ fundamentals, which is likely to continue as the banking sector takes steps to comply with tighter banking regulations, most notably those introduced by Basel III.
For example, the majority of banks globally have seen their core tier one ratio increase year over year, a sign of increased capital strength. The core tier one ratio is a measure of a bank’s financial strength from a regulator’s perspective, and is the ratio of a bank’s core equity capital to its total risk-weighted assets. Furthermore, the ratio of banks’ loans to deposits has decreased in most countries, creating a stronger balance sheet. The regulatory focus on increasing equity content in balance sheets is a clear positive for credit investors. Sovereign risk in the European periphery has undoubtedly had a significant impact on credit, and as a result, some banks are trading cheaply due to investor concerns about how the sovereign debt crisis could affect the sector. The market has arguably priced some issuers harshly, over-estimating the effect that a weaker economy could have on them, which has caused prices to drop and created an attractive buying opportunity. Naturally, investors need to analyse these issuers – and their specific bond issues – thoroughly to determine whether they are likely to be affected by the European periphery’s problems and a weaker economy, or whether their intrinsic value remains intact.
It is a long road ahead and inevitably there will be stumbles along the way. Globally economies are weakening and, in Europe, unemployment is hitting record highs. This must lead to an increase in bad debts for the banking system and a general downgrading of profit forecasts. Nevertheless, some banks are in better shape than others, and will offer investment opportunities as the fog clears. In the current market environment, solid credit analysis must be accompanied by careful consideration of sovereign risks and valuations, but there are certainly issuers with solid fundamentals trading cheaply. Contrary to what many think, there are a number of banks which are part of this camp and may be worth a close look.
Comments