Fri Nov 23, 2012 10:30am EST
(Corrects to show that Cairn has no exposure to peripheral credits in 14th paragraph)
* Subordinated debt rallies despite negative events
* 2012 performance difficult to match
By Helene Durand
LONDON, Nov 23 (IFR) - Investors willing to stick their necks out and buy financial institutions' paper in the dark days of 2011 have been rewarded with handsome returns over the last year, but the sector's phenomenal rally is likely to make the hunt for yield more challenging in 2013.
With Italian 10-year yields approaching 7.75% and Spain's hovering above 6.7%, the prospect of a sovereign default loomed over the entire European banking system. Synthetic credit reflected the market's fears with Markit's Senior Financials index at 353bp and the Subordinated at almost 590bp.
For those who believed that policymakers would not let the euro fail, however, rewards have been handsome. One year on and the iTraxx Senior stands at 170bp with the Subordinated at 295bp, while Italian and Spanish 10-year yields are below 5% and 6% respectively.
The chances of widespread bank failures due to a lack of liquidity were taken off the table when the European Central Bank announced unlimited funds to European banks through the Long Term Refinancing Operation (LTRO).
"Our view at the end of last year was that there was less than a 5% chance of the euro breaking up and as soon as the first LTRO kicked in, we saw hybrid debt fly," said Alex Lasagna, COO and head of investor relations at Algebris.
"We were well positioned to benefit from that as we had bought before the rally. It was never a gamble. We always felt that the risk/rewards were extremely attractive."
Despite the December and February LTROs, investors had to endure a volatile ride until July, when Mario Draghi said he would do whatever it takes to save the euro. Although the ECB has not yet spent a single cent on the Outright Monetary Transactions (OMT) programme, the market has headed in one direction.
And for those positioned down the capital curve, the returns have been spectacular.
Cairn Capital, for example, that launched Cairn Subordinated Financials Fund in October 2011, recently said in a note to investors that the fund had delivered a net return of 30.4% in 2012 and 40.3% since launch.
The story is similar for other funds focused on subordinated financial debt. A CoCo fund launched by Algebris in March 2011 has delivered a 48% return year-to-date, while three Swisscanto CoCo funds show returns over the same period of more than 20%.
"Owning the market was the biggest factor for (performance in) bank capital last year," said Roberto Henriques, financials credit analyst at JP Morgan.
As the end of 2012 approaches, few expect performance in the coming year to be driven in quite the same way.
OLD OR NEW STYLE?
"The likelihood of achieving the same type of return is lower but we still have strong expectations in terms of achieving strong returns," Andrew Jackson, CIO at Cairn. "The universe of assets is shrinking which should help performance."
Jackson said that Cairn's approach would remain cautious, with no exposure to credits in the peripheral jurisdictions.
Algebris's Lasagna agreed, saying that while volatility had nearly halved since the LTROs, there were still some opportunities in the sector, especially if policy makers continued to muddle through.
"Banks will have to roll their old hybrids into new Basel 3 compliant instruments which will be complex. We love it because it's so difficult to price and gives plenty of opportunities."
Algebris's enthusiasm for new-style instruments is not shared by all, even though some banks, like Barclays for example, are keen to push the innovation agenda
Jackson explained that he didn't think investors are being compensated for the risk they are taking given that there is more investor-friendly paper available in the secondary market at attractive levels. "For choice, we would rather look at legacy instruments," he said.
ALPHA, NOT BETA
Last year's stellar returns came despite investors having to dodge issuers offering to buy back debt for as little at 25%-30% of face value, or deciding to break market convention, and the economics of ownership, by refusing to call bonds at their first call date .
If anything, the pace of such things happening is picking up, and then there is the increasing noise around burden-sharing in Spanish banks.
Another opportunity for investors to generate returns has been the downward direction of European bank credit ratings. In November, Moody's said it had downgraded around two-thirds of the senior unsecured ratings of non-peripheral euro-area banks over the 12 months ended 30 September 2012, and nearly 90% of banks in the euro area periphery.
"We like downgrades, we like the fact that it can cause forced sellers for those investors who follow the index," said Cairn's Jackson.
Lasagna said Algebris looks at each institution's balance sheet and decides where it wants to be in the capital structure.
Fear of systemic risk has resulted in high correlation in risk markets but the OMT has removed the so-called tail-risk.
"2012 has essentially been a 'beta' year. If we're right that correlations between asset classes decline, the benefits of alpha should be more apparent," said Stephen Dulake, head of credit research at JP Morgan. (Reporting by Helene Durand, Additional reporting by Alex Chambers, Editing by Julian Baker)
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