Outlook 2012: Living on the Edge

In our 2011 outlook we concluded that “we are positioned for strong company fundamentals and ongoing sovereign debt concerns”. One year later we are in the middle of a system-wide European crisis that is likely to last for a long time. In this respect, the unlimited 3Y LTRO money as well as the eased collateral requirements offered by the ECB are very welcome as these measures will help to reduce the pressure on liquidity.

Note that the measures from the ECB do not directly alleviate the capital concerns for the European banks. Hence, for those banks whose capitalisation is under pressure the incentive to shrink the balance sheet is unchanged. This implies, in our view, that a European credit crunch is likely in 2012. As European companies traditionally rely on bank funding and the European securitisation market is underdeveloped, this could result in a drag on growth as many smaller and medium-sized companies (without direct access to the capital market) will be credit constrained.

The credit market is increasingly being divided into two different asset classes: financials and corporates. For the former, the debt crisis implies a stressed situation and the risk of a negative ‘tail event’. For corporates the outlook is better as the actions undertaken since 2008 have been largely defensive. Having said that, the ongoing distress in the financial system will inevitably feed through to the real economy, thereby putting revenues under pressure. 

Our macro team believes that the European recession fears are overdone and if it indeed comes it is likely to be short lived. In addition, recent data from the US suggest a more positive development. Against this background we are positive on cyclical industrials which we think offer a decent pick-up given that the generally strong balance sheets can withstand tough times. Generally, we think that a prudent approach to credit investments in the beginning of the year is to wait for opportunities in the primary market. In particular when times are tough new issue premiums are often substantial such that syndicate groups and issuers make sure that the transactions go through.  

As we see no quick fix to the debt crisis we recommend to position conservatively going into 2012 and keep some powder dry for the opportunities that might present themselves. Given the correlation between financial and sovereign debt this implies a cautious approach to senior unsecured despite the elevated spreads. Overall, we are neutral on senior unsecured and within the asset class we prefer to position below three years to take advantage of the LTRO. In addition, we would stay in the Nordic region which is not as affected by the sovereign debt crisis as elsewhere.  

At the back of this note we present our top picks for 2012 in the Nordic region. With that we wish you a happy holiday season and a (more) prosperous 2012.  

It's really just a question about the sovereign debt crisis

As we approach Christmas there is not much to be cheerful about. The markets remain unconvinced about whether the policy measures undertaken in Europe (treaty changes, EBA stress test, EFSF, ESM etc) are enough to secure that we will not see a further escalation of the sovereign debt crisis. 

Looking into the crystal ball we only see uncertainty in 2012 (and beyond). What is not uncertain though, is that the sovereign debt crisis will continue which means that volatility will continue.



To indicate the degree of systemic risk one needs only to take a look at the LIBOR-OIS spread which has increased to its highest level in several years and which indicates that banks are currently very reluctant to lend to one another. This is further backed by the behaviour of banks which currently prefer to place their excess liquidity with the ECB instead of placing it in the money market. The 30-day moving average of banks’ recourse to the ECB deposit has reached its highest level ever which underlines that part of the monetary transmission mechanism is broken. Also, when looking at the price of insuring against default of financial institutions it is evident that the trust in the banking system as
a whole is currently fragile and the iTraxx senior financial index has reached its widest level ever. 

European credit crunch may be a threat to growth 

A direct consequence of the sovereign debt crisis is the contagion to the balance sheets of the banks that are holding sovereign and sovereign-related debt in their books. This results in a vicious circle in which the capital position of banks comes under pressure due to mark to market losses on their bond holdings. To reduce risk and to appear more appealing to bond investors banks try to reduce their holdings of such sovereign debt, which in turn adds to the negative price dynamics. 

In addition, following the EBA core tier 1 capital requirement of 9% that was announced a couple of months ago, many banks are now facing capital constraints or even a need to raise new capital. This incentivises banks to reduce their lending volumes as this – for the individual banks – is a cheaper way to increase capital than asking their shareholders for more capital. 

As can be seen from the survey of European credit criteria the ongoing difficulties for the banks translate into ever tighter lending standards. European banks have, on average, been tightening their credit criteria in every single consecutive quarter since the end of 2007 and recently this tightening has gathered pace. At the same time demand has fallen, but it has only recently turned negative compared to the previous quarter. These factors imply a high probability of lending growth to non-financial companies turning negative rather soon, after having moved back into positive territory only recently.

While these actions are completely rational, growth may suffer due to the more difficult access to credit, particularly in countries with sovereign debt problems where the banking sector is most constrained. 



Furthermore, as investors are shunning bank bonds and prices of wholesale funding are elevated (or non-existent) it puts pressure on deposit margins. As many banks are cut off from the wholesale market they are forced to increase their deposit base and are therefore offering increasingly attractive terms on deposit margins. With central bank policy rates very low this results in a deterioration of the deposit margin. 

However, there is one important element pointing in the other direction – namely the unlimited 3Y LTROs offered by the ECB at attractive terms. These operations will provide the banks will ample medium-term liquidity, which is likely to be put at work during 2012. In our view this will especially benefit the shorter part of the curve (below three years) as we think this is where banks will place most of the allotted liquidity from the LTRO at the current stage. 

The large corporates in safer territory

We think that larger companies with access to the bond market are much better prepared for a period with difficult access to liquidity than in 2008 when the capital markets froze. Balance sheets are more liquid and it has been a clear objective for many a treasurer to increase the diversification of the funding base, thereby reducing the dependence on the banks. Having said that, the European crisis this year has meant that the substantial growth in the use of corporate bonds that took place in 2009 and 2010 (see chart) has come to a halt as a consequence of the difficult market environment during the latter part
of the year in particular. 



Over the coming years we expect renewed European growth for corporate bonds as a consequence of the restriction on bank balance sheets. In the short term, however, bond issuance will depend on the outcome of the euro debt crisis and 2012 may therefore prove to be a slow year in terms of issuance. According to a study by Fitch the larger European companies have already turned to the bond market to a larger degree. Since 2006 the amount of outstanding bonds for the 161 companies in the sample has increased by more
than 50%, which by far surpasses the level of bank loans in the same period.  
For smaller and medium-sized companies that lack the critical mass to use the bond market, the situation is different and much more challenging as financing and refinancing are likely to be difficult. This could act as an impediment to growth.

Investment approach

Our overall investment approach is one of caution. For investors who can stomach high volatility and are not too sensitive to mark to market fluctuations a more aggressive strategy would make sense in order to take advantage of the high risk premiums.

Despite the grim fundamental outlook for banks given the debt crisis there are also some factors that suggest that the asset class may be oversold. First of all, it remains unlikely that we will see haircuts on senior unsecured in the short to medium term – even if banks come close to failure. This is especially the case outside the European periphery. In this respect note that the bail-in directive is a positive driver for outstanding senior unsecured as these are likely to be grandfathered for some years and it may even be that only newly issued bonds from a certain date will be subject to the specific bail-in provisions. When the directive is presented – probably rather soon – we will have final clarification on this matter. 

Second, the availability of term liquidity through the LTRO is also likely to result in a very modest issuance pipeline for senior unsecured in 2012 as banks have tapped EUR489bn in the first auction. In fact, the net new issuance is likely to be very negative as there are redemptions of more than EUR300bn of senior unsecured financials in 2012. Coupled with ample liquidity at the banks, which may be put to work at some stage, this could be a catalyst for some spread tightening. Finally, spreads are wide. The spreads of senior financials are back around the levels where we saw distressed selling in the wake of the Lehman Brothers collapse. 

At this stage we prefer to wait for more clarity on the debt crisis before we dip our toes into the senior unsecured market. Overall, we therefore recommend a neutral positioning on senior financials. We prefer the shorter part (below three years) of the curve due to the LTRO, which we think will be particular beneficial for this segment. 



Compared to financials, corporates will be less volatile going forward as the correlation with the debt crisis is lower, but mostly so for the companies not domiciled in the periphery countries. Default rates are likely to increase going forward, but from a low level and most likely to stay below the average historical rate of 3.75%. If the recession proves tougher than what we currently expect, default rates may prove to increase more rapidly, but the fact that company balance sheets are generally strong should guard against a major increase. With ‘BBB’ corporates currently trading at around ASW +250bp and ’A’ corporates at around ASW +100bp we think the pick-up for the credit risk is attractive. Among the corporate we  prefer the industrial sector and given the
strength of the balance sheets we think some of the cyclical names in the Nordic region are attractive.
 
In addition we think the corporate credit market is likely to continue to be subject to substantial investor interest as many investors are cash rich following limited issuance in 2011. It is likely that we will see some new issuance from non-financials in particular during 2012 as bank terms are likely to get tougher. This would be the time to start adding credit exposure again, we think, as the rebirth of the primary market is likely to imply a re-pricing against existing secondary market levels.

Subordinated financials: The genie is out of the bottle - Higher extension risk 

Subordinated debt has become complicated again. With the banks under renewed pressure in 2011, the prices of sub debt have fallen significantly. This has prompted a flurry of liability management exercises (LME) from a large number of European banks. 

For banks, the incentive of LME is that the depressed market prices creates an
opportunity for banks to “create” Core Tier 1 capital as they buy back bonds at prices much below par that are booked in the accounts at par. This creates a profit through the P&L and thereby an increase in the Core Tier 1 capital. On the other hand, it lowers the total capital. EBA, the Basel committee and rating agencies have a clear preference for Core Tier 1 capital and therefore such a move makes sense from a capital management perspective. In addition, the LTRO has reduced the opportunity costs for the funding such operations require. Thereby, the implicit costs of making a tender have been reduced. 

Some of the banks that have tendered/exchanged have made it clear that future decisions to call outstanding sub debt will be made on economic grounds. Hence, the probability of these banks not calling is high. As we see it, this means that the genie is out of the bottle for banks and that potentially a large number of them will decide not to call their sub debt – this is especially the case in the periphery countries where funding levels are elevated (if possible to get funding at all).  

In the Nordic region, we think the situation is a little different and we consider extension risk to be lower compared to elsewhere in Europe. First of all, the Core Tier 1 capital ratios of the large Nordic banks are high and therefore the need to create Core Tier 1 capital is lower. Furthermore, the cash prices of the subordinated instruments are far from as depressed as elsewhere in Europe and the capital gain of tendering is therefore lower. Secondly, the Nordic banks have gained a position as a safe haven among European banks, thereby benefitting from lower funding levels and a better reputation. This implies that the banks have access to replacement funding at reasonable levels and therefore exchanges would make less economic sense. With funding and capital being less of an issue for Nordic banks we therefore think that the upside is limited and not adequate to offset any damage to reputation a non-call would potentially cause. 

Having said all this, we need to stress that extension risk has increased also for Nordic banks as the stigma of not calling is becoming lower. Still, our base case is that the large Nordic banks will call their subordinated debt at first call. Note though, that CMS hybrids are not likely to be called and in this respect Jyske Bank - who made a tender offer for some of their outstanding Tier 1 CMS - has underlined that "any future decisions as to whether Jyske will exercise calls in respect of capital securities not tendered pursuant to the Offer will be taken with regard to the economic impact of exercising such calls in the then prevailing market conditions”.