Regulatory pressure, changes to the market structure and an ongoing de-leveraging process make the financial sector compelling for bondholders, argue Robert Montague and Satish Pulle

The European financial sector faces its most severe crisis since World War II and it is imperative that European countries, the ECB and financial institutions set aside antagonism and work together to resolve it. At the time of writing, we are still waiting for a comprehensive package that addresses the three legs of this crisis - bank capital, bank funding and sovereign funding. At this stage, the amount of money required to address these inter-connected issues is still within the wherewithal of EU governments and the ECB.

The bank capital problem can be resolved if European sovereigns invest €250-300bn in non-dilutive contingent capital, following the example of the US. Just as the TARP programme invested $700bn (€523bn) in US banks, European countries should also make a temporary investment because markets are currently not functioning. While most EU countries can manage recapitalisation themselves, Italy and Spain would need to borrow from the EFSF - yet the amount is limited to €135bn in total for both countries.

To address bank funding, we would like to see the ECB immediately provide €2trn in 24-month funding to European banks at a low fixed rate, against good-quality collateral. Of this, €450bn needs to be given to Italian and Spanish banks. To address sovereign funding, particularly in Italy and Spain, banks and insurers should publicly commit to buy the substantial majority of their country’s sovereign bond issuance over the next 24 months. If, through these steps, Italian and Spanish bond yields are kept below the 6.5-7% level, these countries can recover slowly.

The amounts involved are manageable. The key institutions have the required legal authority. Only a lack of political will prevents Europe from this type of comprehensive solution.

Historically attractive
For credit investors willing to take a medium to long-term view, the current crisis offers a significant opportunity to invest in European bank debt at historically attractive levels. The iTraxx senior index (an index of the senior CDS spreads of the leading 25 European financial institutions) is, at the time of writing, trading at 3%, close to its all-time wide levels and far higher than during the Lehman collapse in 2008-09. This is pricing in a probability that nearly a quarter of these 25 institutions will default in the next five years.

While not wanting to underplay the significant short-term risks, we feel that the extensive balance sheet de-risking that European banks have already carried out and continue to undertake is a positive for credit investors.

First, banks have significantly strengthened the amount and quality of their capital in recent years, be it through new capital raisings or higher earnings retention. Core tier 1 ratios are now, on average, 50% higher than they were three years ago and are likely to rise further as banks aim to meet the stiffer regulatory requirements of CRD IV (the EU version of Basel III).

Second, European banks are in deleveraging mode; they are either running off or selling individual assets, or they are disposing of whole businesses that do not fit in with their strategy or fail to achieve a sufficient risk-adjusted return. Consensus estimates suggest that major European banks will shrink their balance sheets by €1.5-2trn over the next few years.

Third, banks are improving their liquidity profiles by raising the proportion of central-bank-eligible assets. For example, RBS has nearly doubled its liquidity buffer since 2008. Banks have also been reducing their reliance on short-term wholesale borrowing, replacing it with longer-term wholesale funding or retail deposits.

Bank deleveraging is, to a large extent, being driven by tougher global regulation. While current Basel II rules demand a minimum common equity tier 1 ratio of 2%, the new Basel III proposals require a 7% minimum. In addition, global systemically important banks (G-SIBs) will be required to hold an extra 1-2.5% capital. Banks will also have to conform to global liquidity and funding requirements (liquidity coverage and net stable funding ratios) for the first time. Governments around the world have set up ‘financial stability boards’ whose main task is to spot and prick bubbles before they threaten the system.

The effect of this increased regulation in terms of higher costs and capital requirements will undoubtedly put pressure on earnings and ultimately equity returns. But in reducing the riskiness of banks and their earnings volatility, it provides strong support for bondholders.

The price of European insurers’ subordinated debt has fallen sharply recently, partly on fears of contagion from banks and the perception of their sovereign exposure. Although European insurers own about 8% of peripheral euro-zone sovereign debt, the net amount of potential losses that the companies are exposed to is much lower than the gross amount, since they can pass on roughly two-thirds of any losses to policyholders.

Coming into the crisis, European insurers were in a better financial position than their banking peers, having experienced their own catharsis following the post-internet equity market crash. They had considerably de-risked their balance sheets (aided by a better understanding of the risks they run through the introduction of internal risk and economic capital models) - in particular, reducing equity allocations within their investment portfolios. Another important structural difference between banks and insurers is the contrasting funding models, with insurers’ minimal reliance on debt markets. Insurers’ funding requirements can be almost wholly met by policyholder premiums and capital markets are only used for regulatory capital purposes.

Limited specialist insurance credit research coverage is a ‘technical’ factor that discourages lay investors, providing specialist investors with a particularly good hunting ground.

Similarly, regulatory changes are leading to changes in investor behaviour which affect the relative pricing of various classes of bank debt. The proposed liquidity coverage ratio (LCR) will discourage banks from buying other banks’ senior and subordinated paper, while encouraging purchases of government and covered bonds. Solvency II is forcing insurers out of hybrid bank bonds due to higher capital charges for these longer-maturity, lower-rated bonds.

In the UK, the Independent Commission on Banking’s (ICB) proposal to introduce a bail-in regime for senior debt and ring-fence retail operations has led investors to demand a higher premium for UK bank bonds, based on uncertainty about whether bondholders will be within or outside the ring-fence. Meanwhile, new bank resolution laws being introduced across Europe lead to lower ratings, particularly for subordinated bonds, constraining index-benchmarked investment-grade bond funds from investing in this sector.

In the longer term, we expect subordinated financials to be managed in a fashion similar to high yield, led by specialist funds and some involvement from mainstream funds. Over the next 10-15 years the combination of improving credit risk and new constraints on the existing investor base will result in high risk-adjusted returns in the subordinated financials sector.

Yet, given the ongoing uncertainty regarding euro-zone sovereign funding, in the short term we are investing only in the most senior parts of the capital structure - covered bonds and senior unsecured - although we are happy to own selected subordinated bonds in very strong banks such as HSBC, Rabobank, Nordea, Svenska Handelsbanken, Credit Suisse and Standard Chartered. While many banks have, so far, called their subordinated debt at the first call date, we remain concerned about future calls. We are also concerned about coupon deferrals on the most junior class of subordinated bonds (tier 1).

We like most of the major European insurers, with the possible exception of those particularly vulnerable to euro-zone sovereign funding headline risk. We would consider investing in subordinated debt, given the strong regulatory incentive for insurers to call existing hybrid debt at their first call date, since most of it will no longer qualify as regulatory capital under Solvency II.

In conclusion, we think that the combination of ultimately lower-risk, utility-type business profiles for banks and the on-going high yields on offer for both bank and insurance bonds makes the financial sector attractive on a medium to long-term basis, for credit investors. Yet, specialist focus is necessary, as the sector will undergo structural change, with many mergers and break-ups, recapitalisations and asset sales.

Robert Montague is senior investment analyst and Satish Pulle lead portfolio manager at European Credit Management