Libor: the impact on credit

Banks are plagued with scandals and poor capitalisation. How should credit investors approach deep problems in an important part of their universe?

It seems almost every morning we wake up to hear about another banking scandal, from major IT breakdowns to massive money laundering lapses. The Libor rate-fixing exposures may yet prove to be the worst, with institutions potentially liable for damages on the scale of the asbestos or tobacco industries.

A further layer of unease is debt related to the eurozone. Banks at their most basic are leveraged plays on their national economies, which makes institutions in the eurozone periphery subject to particular caution. However a number of banks in the core, particularly France, are significant holders of debt, both sovereign and private, originating in the periphery.

As if the issues grabbing headlines in the mainstream media were not enough, banks have been upsetting credit investors on more technical levels. A particular bugbear is the ‘liability management exercises’, aggressive tenders for outstanding bonds which banks have been forcing through in response to regulator pressure to improve their balance sheets. These are defaults by another name and in themselves justify extreme caution in approaching the sector.
Whether your personal response to the latest round of scandals is outrage or schadenfreude, the depth and scale of the issues facing the banking sector raises problems for sterling-based credit investors. Banks are by the far the most significant issuers of corporate debt, accounting for about half of the secondary market. How should we approach institutions exposed to Libor risk and what alternatives should we consider?

Libor-related risk involves potentially high sums, while the list of banks at risk is long and widely spread, including the main UK names and the largest institutions in France, Switzerland, Japan and the US. In the US, claims for damages are normally confined to those who did business directly with the defendant. In respect of Libor, it seems this rule may be overriden, allowing anyone who suffered losses to make a claim. This could exponentially widen the pool of potential claimants.
Fines may be scaled to an institution’s financial strength, but the level of civil claims is likely to be determined by a judgment on the losses suffered by the claimant. Smaller, less profitable and poorly capitalised institutions may find themselves equally liable as their larger, profitable, well capitalised counterparts. As investors, insofar as Libor banks are too large and too numerous to avoid altogether, and until the extent of liabilities has been clarified, we should tend to favour the latter over the former.

In looking for alternatives, there are some interesting choices. One good choice, in our view, is the US super-regionals. Leading names here include PNC, US Bancorp and Wells Fargo. These institutions have neither Libor nor eurozone baggage. They are a way to express the relative strength of the US economy. The housing market writedowns, which plagued the sector in previous years, are largely in the past and housing is now one of the brighter spots of the US economy. They are also significantly more profitable than European banks, with average net interest margin comfortably double that typical in Europe.
Another alternative is the Nordic names. These include Nordea and Svenska Handelsbanken. They have many of the same characteristics as the US super-regionals. They are based in stable economies, with strong credit metrics and without Libor and eurozone periphery tail-risk.
Looking at non-bank financials, the picture is significantly brighter, and names in this area provide another good alternative for investors. The return this sector offers is similar to that offered in banks but without much of the risks. Given the inherent business model, the insurance sector is much more lowly levered and liquidity risk is lower than that with banks. As 2011 has shown (the second most expensive catastrophe year on record) the European insurance sector is resilient to catastrophes - those names with large P&C businesses remained profitable throughout.
However, not all names in the insurance sector benefit from strong fundamental credit profiles. That-being-said the names we like seem highly profitable, have a good grasp of the risk they are underwriting and have little or no investment exposure to peripheral Europe. In life insurance we favour names like Prudential and Legal and General, in non-life we like RSA and in reinsurance Munich Re and Swiss Re. Large European reinsurers in particular have strong credit profiles together with robust earnings.
Looking outside financials we see strong opportunity in a number of sectors. One of our preferred themes is for companies providing basic goods on a global scale – packaging, capital machinery, vehicles. These are companies which we see as being highly resilient in an environment of low economic growth. They are financially robust, with strong balance sheets and good free cash flow. We also like cable companies, which have the utility-like characteristic of stick cash flows, but with better growth prospects and higher yield.
Companies we prefer among non-financials are ‘rising stars’ (as opposed to ‘fallen angels’), companies that tend to be on the ‘cross-over’, straddling high yield and investment grade. Examples include, Chrysler, Ford and Jaguar. In capital goods we recently bought GKN. Among cable operators we like Unity and KDG.
We have been underweight banks for some time on the basis of their problems with eurozone exposure and poor capitalisation. The Libor revelations have not required a radical reappraisal of the portfolio but have led to more emphatic positioning. They have also added years to the time we think it will take before the banks return to favour.