Bonds sit well on cushion from sales

Banks recoup losses from the wealthier of writedowns by the sale of assets - bad for equities but good for bond holders. So investors should boost exposure to high-quality financial credit.

Banks recoup losses from the wealthier of writedowns by the sale of assets – bad for equities but good for bond holders. So investors should boost exposure to high-quality financial credit.

When Bradford & Bingley raised £400m from its recent rights issue it marked the latest chapter in an ongoing cycle of recapitalisations that are taking place across the global financial sector.

Spurred on by £284 billion worth of writedowns in the value of certain assets, commercial and investment banks managed to raise £196 billion of fresh capital to offset the pressure of these losses on their balance sheets and capital ratios.

While these capital raisings have often been done at the expense of equity holders – who have seen their holdings diluted or suffered a sharp decline in the value of their equity as it falls towards a deeply discounted rights price – they have generally been much more positive for bond holders.

Banks have two main choices for recapitalisation: they can dispose of assets and attempt to shrink their balance sheets, thus decreasing (risk-weighted) assets and consequently increasing their capital ratios indirectly; or, they can directly increase their capital ratio by issuing fresh capital. Some banks may also look to do both.

Citigroup, on the back of $55.1 billion (£31.3 billion) of losses, raised $49.1 billion of capital through issuance of common equity, convertible preferred stock (mainly to sovereign wealth funds), as well as the sale of its German consumer unit to Crédit Mutuel for $4 billion.

In Britain, banks such as RBS, HBOS, Barclays and Bradford & Bingley all raised additional capital to shore up their balance sheets and, in many cases, a greater amount of capital than they had to take as losses. When the capital raised is equity, it is subordinated to debt in the capital structure so this can be good news for a bond holder.

Higher equity effectively means that there is a larger loss absorbency “cushion” below debt holders, thus providing greater protection from any further losses before any debt can be affected.

Further, because equity is a component of “core” tier one capital, a higher equity component also translates into a higher core capital ratio. This metric is used as an important indicator of the financial strength of an institution. Given the losses seen at banks, along with the tougher operating environment they are facing, it is positive that core capital ratios have increased.

HBOS, for example, talked about a “step change” in its capital strength and target ratios when it announced its rights issue, and other banks have made similar utterances.

Nobody would suggest that losses are a good thing for either equity or bond holders, but any damage caused by such losses can be more limited for bond holders when there is an offsetting increase in more subordinated capital.

Of course, there are limitations as to how far any losses can realistically be offset by raising fresh capital – a bank is not in the same position after a loss and capital raise as it was pre-loss, even if the numbers match up exactly.

The financial flexibility of the institution is reduced once a capital raising action has been done. Assets can only be sold once and the practical reality of a public rights issue is that a bank may only have one real shot at it. Once a source of capital is utilised, the institution has less to fall back on if more is required in the future.

There is also a growing concern Region Total losses Total capital raised(£ billion) (£ billion)Americas 141.0 99.4

Europe 129.9 84.1

Asia 13.2 12.2

Total Worldwide 284.1 195.7

that capital available to institutions from sovereign wealth funds and the general public is running low. This was demonstrated recently by the 8% public take-up of the HBOS rights issue.

Also, sovereign wealth funds’ appetite to continue investing in western financial institutions may be tested given that their recent investments, while longer term, are under water.However, despite these ongoing concerns, the general perception in the market is that recapitalisation still has further to run.

Given the impact that recapitalisation can have on banking institutions, this then has big implications for ongoing fund management strategy.

Bank credit spreads are trading at historically wide levels (see graph) as they continue to price in a high level of defaults, mainly as a result of further expected losses, macroeconomic downturns and the continued dislocation in the funding markets.

However, on the basis that recapitalisation is set to continue for some time, the primary loss of wealth is likely to accrue to equity holders, not bond holders. Therefore, while equity underperformance has been fully justified and may have some way still to go, the same cannot necessarily be said of the credit markets.

While some amount of the spread widening seen in financial bonds is justified given the environment and challenges faced by banks, the significant movement that the market has witnessed in the past 12 months is excessive and, ultimately, unjustified.

On this basis, a strategic overweight in high quality financial credit looks like the smart trade to have on over the next few years, possibly accompanied by an underweight in financial equity. Long live recapitalisation.