Bank bonds: yields are very generous and current price may be an attractive entrance point

In the last weeks two national champion banks with strong and diversified franchises, Deutsche Bank and Credit Suisse, have announced large headline losses, triggering a sell-off in their shares and bonds. Both banks used significant capital in their investment banking activities in early 2000s and have legacy and litigation issues which are coming home to roost. But they also both have new hard-headed managers in charge, who aim to reshape their businesses so that the important cash generative franchises they own come to the fore and the value for equity holders can be rebuilt. This will take time and the litigation issues must be resolved. Sometimes goodwill will be written off as in the 16 year old goodwill for the Donaldson, Lufkin & Jenrette acquisition by Credit Suisse. But goodwill is a non-cash item so that investors should look through some of the published losses and focus on real cash generating ability.
When we focus on cash generation, particularly in the reshaped or reshaping investment banks, we should also note short-term gyrations. Credit spreads have widened, stock markets have been poor, but unless there is a major global recession earnings will be cyclically weak and will rebound as markets recover, even if from a lower base. Time for adjustment will be needed but there should be no major systemic shock. We will hear more about rising default levels, particularly in the energy sector, but it would be wrong to exaggerate those issues. Unsecured loans to Exxon, Shell and BP will not default and short term energy trade finance will still be profitable. Losses may be taken by banks on idiosyncratic loans and weaker credits that were able to raise money in better markets. However we would expect this to be manageable for the major banks and not to derail their capital strengthening. In some cases, banks may need to go back to their shareholders through discounted rights issues as they have done in the past years. But strengthening of the banks’ equity is making subordinated debt and particularly senior subordinated debt more attractive.
We stick with banks with high quality businesses and business models that we believe can be reshaped eventually to benefit and rebuild equity values. We will avoid buying debt of banks that are in troubled zones or that have questionable business models. We prefer older legacy securities as banks reshape their balance sheets for debt that is losing its regulatory capital advantages. For example, Deutsche Bank repaid some old floating rate notes this month at 100% after they were trading at 60% the day before the announcement. We are a bit more cautious on the new contingent capital securities (CoCos), choosing only the best franchises and limiting our exposure. Good analysis is required and dogmatism must be avoided. For certain bonds the yields are currently very generous and the current price setback may be an attractive entrance point.

Anthony Smouha, manager of GAM Star Credit Opportunities fund