In the aftermath of the 2008 financial crisis, the ongoing process of bank recapitalisation presents a compelling opportunity for bond investors, says Ariel Bezalel (pictured), manager of the Jupiter Strategic Bond Fund…
Developing positions in the banking sector
In Q3 2012, we took the decision to develop positions in the deeply subordinated bonds issued by banks in the UK and Germany. With central bank policy becoming more progressive in Europe (Mario Draghi would soon make his “do whatever it takes” pledge) and the US (QE3 was on its way), we were attracted to the sort of value on offer for an industry in the midst of a recapitalisation process that could present a multi-year investment opportunity for bond holders.
Treading cautiously, we invested in the tier 1 and lower tier 2 paper of industry “heavyweights”, such as Lloyds, Barclays, Royal Bank of Scotland and Commerzbank.
Ultimately, we believed banks would start to exhibit utility-like characteristics. As a high conviction theme in the Jupiter Strategic Bond Fund, bank bonds account for about 23% of the high yield bonds held in the Fund.
Strengthening balance sheets
At some 7% of the Fund, Lloyds is the largest holding from the sector and is emblematic of the changes occurring across the sector. The bank, which is the largest mortgage and retail savings provider in the UK, is not only a play on the UK economic recovery, but is making solid progress on its strategic plans. Non-core assets are being reduced. Profitability is up. It has a fully loaded Basel III tier 1 capital ratio of over 10% and has a leverage ratio comfortably above current regulatory requirements. In addition to the bank’s longer term deleveraging plans, we are attracted to its general focus on conventional banking rather than investment banking.
Strategic opportunities
Part of the bank deleveraging story involves changes to the sort of capital banks hold on their balance sheets. These changes effectively mean older-style tier 2 and other subordinated paper may no longer be fit for purpose when banks are subject to stress test. In light of these changes we have taken tactical positions in these sorts of bonds on the expectation that they would be tendered at a premium to current market rates.
In early March, Lloyds announced just such a move when it made a tender offer for roughly GBP8bn worth of its outstanding Enhanced Capital Notes (ECN). These contingent convertible bonds (aka CoCos) were issued in 2009 when the bank needed to raise capital to meet FSA stress tests, but have since been deemed insufficient under new definitions about what constitutes core capital.
When investing in bonds, the devil is in the detail, and this rather technical change has created quite an interesting investment opportunity, in our view. As part of its tender offer, Lloyds is giving bondholders the option to exchange into GBP5bn of new Additional Tier 1 securities at favourable prices. This has benefitted investors in the Jupiter Strategic Bond Fund, which at the time of the offer had a c.3% weighting in these notes.
Special situations as legacies are addressed
The process of healing after the financial crisis continues to offer selective special situations for bond investors.
A tactical holding in distressed Austrian Bank Hypo Alpe Adria is a recent example. We bought into the bank’s senior bonds in December 2013 and topped up our holdings in February this year. These were purchased at high single-digit yields (some at yields in excess of 30% annualised) amid concern that insolvency problems could lead to a haircut for bond holders. The bank obviously had quite serious liquidity problems. However our research had led us to believe that the senior bonds, which are under guarantee from the southern Austrian state of Carinthia, would remain untouched.
A position like this is not without risk, which has been reflected by a cautious weighting in the portfolio. However, our view came down to the fact that Hypo Alpe Adria is systemically important to the Austrian economy. In an attempt to control the economic costs associated with reorganising the bank (i.e. if the bank were to survive), it was in the government’s interest to maintain financial stability at the institution and honour its commitment to the senior bonds.
This view was ultimately vindicated. On 14th March 2014 the Austrian Finance Minister ruled out a bail-in for senior bond holders when he announced plans to clean up the bank’s balance sheet. Other investors may be less fortunate. As part of the restructuring process, some assets will be ring fenced and investors in certain subordinated debt and non-voting participation capital are expected to take a hit.
The holdings in these bonds have since added value to the Fund.
RBS provides a similar example. Bonds in RBS struggled in Q3 2013 amid concern that the bank would be broken up. We believed such a move was unlikely given the potential cost and complexity, and also formed the view that a move may necessarily work against bond holders. Nevertheless, market speculation about the bank’s future led to a period of underperformance for our material holding in the bank’s bonds until November, when it was announced that a GBP38 billion internal “bad bank” would be created. This news provided a significant boost for the bonds.
Note: Past performance is not a guide to the future. The value of investments may fall as well as rise and you may get back less than originally invested. The Fund can invest a large portion of the portfolio in high yield and non-rated bonds. These may offer a higher income, but capital value is at greater risk, particularly during market volatility. Quarterly income payments will fluctuate. The fund uses derivatives, which increases volatility and performance is unlikely to track the performance of broader markets. Losses on short positions may be unlimited. Counterparty risk may cause losses to the Fund. . This Fund can invest more than 35% of its value in securities issued or guaranteed by an EEA state. The Key Investor Information Document (KIID), Supplementary Information Document (SID) and Scheme Particulars are available from Jupiter on request.
Any stock examples are used for illustrative purposes only and should not be viewed as investment advice.
The above commentary represents the views of the Fund Manager at the time of preparation and may be subject to change and this is particularly likely during periods of rapidly changing market circumstances. Their views are not necessarily those of Jupiter and should not be interpreted as investment advice. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given.
Jupiter Unit Trust Managers Limited (JUTM) and Jupiter Asset Management Limited (JAM) are both authorised and regulated by the Financial Conduct Authority and their registered address is 1 Grosvenor Place, London SW1X 7JJ. They are both subsidiaries of Jupiter Investment Management Group Limited and the group is collectively known as "Jupiter”.
