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Battered bank bonds will emerge stronger, says AAA-rated manager

Renewed fears about Europe's banks has hurt their bonds but top manager Anthony Smouha says they will be strengthened by reforms.

Battered bank bonds will emerge stronger, says AAA-rated manager

The sell-off in Deutsche Bank and Credit Suisse bonds and shares caused by the banks’ end of year reports is not a death knell for fixed income investors in the sector.

That is according to Citywire AAA-rated Anthony Smouha, who works for Geneva-based Atlanticomnium and manages the GAM Star Credit Opportunities fund.

In an investor update, Smouha said both banks used significant capital in their investment banking activities in early 2000s which is now having a negative effect. However, Smouha thinks recent management changes had not had time to take effect.

‘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,’ he said.

Where to buy

Smouha currently has a 4.3% holding in Lloyds Bank, which is the largest allocation in the fund. Other banks include HSBC (3.1%) and BNP Paribas (2.7%).

‘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,’ Smouha said.

Smouha added there could be short-term losses as credit spreads - the gap between yields on corporate government bonds - had widened. As bond prices move in the opposite direction to yields, this meant some bonds had performed poorly, although he thought this had created opportunities in some subordinated, lower ranking debt.

‘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,’ Smouha said.

‘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.’

The GAM Star Credit Opportunities fund has generated a total return of 30.3% in the past three years to the end of January, ranking it first out of 58 funds in the Sterling Bonds sector.

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