Finding Value In European Credit

Includes: IBDRY, IRE, LYG
by: Zachary Latif

What a difference a year makes!

The LTRO was mentioned as a potential game changer, and the increased liquidity through this 3 year funding program has been a major catalyst for the recent risk asset rally. The "Black Swan" event of a complete market shut down with bank failures and a euro break-up were easy to visualize late in 2011, but the fact that the ECB has decided to embrace fiscal support and set off on a 3 year bank funding mission has at least taken the unthinkable off the table. The perfect storm for a sustained rally would not be complete without the Fed coming out with a statement prolonging super low interest rates for at least another year and a half.

Great for long term loans but bad for deposit holders? And this is where I think the opportunity within credit becomes so interesting for any discerning investor. One of my greatest bug bears has been the number of "unsophisticated" investors within equity markets (in spite of the greater volatility relative to credit), but now with interest rates so low, surely it is time for a number of smaller investors to start investing in credit.

Financials have a very interesting risk-return profile in this environment and are very attractive to opportunistic investors. One of my favorites, Lloyds' (NYSE:LYG) 7.5884% ECN note, (ISIN XS0459086582) currently trading at mid-80s cash price, implies a yield of around 10%. The risks associated with ECNs have reduced substantially over the last few months, and expect Lloyds to call this well before maturity date; so yield level can be a lot more compelling. Indeed the optionality in callable LT2 bond is not being priced into these instruments, implying a low to no probability of call. ISPIM 5.75'18 (XS0365303675), currently around high 80s cash price, has a yield to maturity of 5.67%, but if called implied return of over 15% (May 13 call date).

Or why not look at Italian 5yr dollar denominated government bonds (cash price 101.10 yield return 5.1%)? With the threat of implosion now a mere dot in the horizon and a Greek debt deal nearing completion this can be a nice coupon trade, while at the same time, a very compelling story to continue to grind in.

If the trades above require investors to take a little more risk than acceptable in the current volatile market, yields of 3-6% are very achievable on benchmark liquid name, and surely that's a more interesting proposition than 0.5% offered in the current account. IBESM 3.5'15 (XS0222372178) is issued by Iberdrola (OTCPK:IBDRY), Spain's largest utility group with businesses in UK and US, and trades at slightly above par, implying a yield of around 3%. TITIM 4.95'14 (US87927VAL27) at near par and is also yielding 4.84% and given its international profile, with a near monopoly in Italy and strong presence in South America, is a good way to take a position in a safe but yielding asset.

With liquidity no longer a concern, capital raising remains the biggest challenge for European banks (the EBA has told banks to raise $150bn by Jun 12), given how distressed secondary levels had become on Bank paper (across all spectrum: unsecured, covered and asset backed). The easiest way for banks to improve capital ratios is to launch buy backs (tenders) for these products. It's the perfect zero sum game, normally the premium over current secondary levels makes it attractive for investors to tender their bonds to the originating bank, while for the bank it's an easy fix to improve their core Tier 1 ratio.

My favorite dark horse is Ireland; their response to the sovereign crisis has been the most credible (Michael Lewis's attempt notwithstanding) and the current sovereign/ financial rally is fully justified, given the fact that their medium term debt sustainability is credible. They have been the most active in announcing (and more importantly implementing) austerity measures, their economy remains significantly more competitive to other peripheral (or even mainstream) European nations, and with 10 year yields around 10%, this will continue to grind tighter based on positive economic growth this year. House price correction remains a concern but there is a lot to like about the Celtic Tigers. I like the covered bond profiles for both Bank of Ireland (NYSE:IRE) (BKIR'13 cash price 95.11 with 7.78%), while Emerald Building Society have an outstanding issue, EBS '12 is potentially a great trade with a maturity in November of this year at 95 cash price and 11%.

Fundamentally I remain bullish going into the short term; it feels a lot like early 2009 soon after Lehman's collapse when the US announced TARP and other liquidity measures, which led to a furious rally in risk assets. This time, the ECB has reluctantly taken the mantle and while one can argue the systemic risks remain, the liquidity measures announced will once again lead to a sustained (and since this is Europe, I suspect slightly more subdued) rally. It's time to pile into risk!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Thinking of initiating a long position in LBP Capital No.1 LLOYDS 7.5884 20 XS0459086582.