Fixed IncomeMay 13 2013

A good capital preservation play

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Our first key trade at the moment is a focus on capital preservation. There are two strands to this, a large underweight to the banking sector alongside an allocation to short-dated gilts.

The traditional funding mechanism for banks has disappeared post the crisis in 2008. Instead of issuing senior bonds to generate funding, they are instead looking at other areas – such as the issuance of quasi-equity debt and other contingent capital instruments, known as cocos, which are much higher risk from a bondholder perspective.

While it does appear the banks have stabilised since the height of the crisis, given huge liquidity injections from central banks, there are still many reasons why you would not look to invest in European institutions.

The demise of Dutch bank SNS Reaal is a prime example of how the game might have changed for traditional bondholders. If the downfall of SNS is going to be the new prototype for wind-ups, then the market is materially underestimating how much of an impact this will have on credit investors, even senior creditors.

Unlike in many previous European bank bailouts, junior SNS Reaal bondholders were not bailed out and lost their entire investment. The architect of the SNS nationalisation was Jeroen Dijsselbloem, the Dutch minister of finance.

Mr Dijsselbloem is currently the eurogroup president and president of the board of governors of the European Stability Mechanism bailout facility. He also led the negotiations of the widely-criticised Cyprus bail-in, which set a terrible precedent by taking from the accounts of depositors.

Mr Dijsselbloem’s influence is currently a major threat for bondholders of European banks, and he has recently said the forthcoming European Central Bank stress tests on banks may uncover balance sheet weaknesses that would result in further write-downs for bondholders.

Why would we lend to a sector where we are highly unsure if we will get our money back? In the case of SNS, the price of these bonds went to zero literally overnight, and the risk/reward opportunity from investing in similar European banks is especially poor. Where we do have banking exposures, we hold Asian-focused HSBC and Standard Chartered, along with some holdings in stronger UK and US banks. We have no exposure to Spanish, Italian, Portuguese, Irish or even German banks.

The second part of our capital preservation play is in the holding of short-dated gilts. These are very liquid and will protect us if corporate bond spreads widen.