Alberto Gallo: Focus on credit niches as Europe recovers

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Europe’s turnaround should become a full-fledged recovery in the coming year as governments ease austerity and banks slow the pace of deleveraging.

Alberto Gallo, Head of European Macro Credit Research, RBS

Europe’s comeback could make it the top fixed income destination in the coming 12 months, even though rewards are modest as investors sense improvement and flock back.

Returns on European investment-grade corporate debt should fall to around 2.2 per cent from 2.6 per cent in 2013 while high-yield debt should return a modest 5.1 per cent compared to 9.4 per cent this year.

There are a few oases in the yield desert. One might be senior debt issued by banks in Europe’s periphery. Though holders of subordinated debt may face dilution as a result of banks’ need for capital, senior bondholders should avoid losses and benefit from declining political risks and improving economic growth.

Investors may find equally attractive niches in less-liquid credit markets. Fixed income investors have so far been chasing sovereign, corporate and bank bonds and largely ignoring the wider credit market. Where capital has been scarcer - in direct bank lending, securitisations and high-yield bonds - returns have remained higher.

With European initiatives to promote securitisation, such as European Investment Bank (EIB) programmes, the CLO market should stage a recovery in 2014. The high-yield corporate market should also continue to grow, having tripled in size since the start of the crisis.

Emerging markets look vulnerable however. Rising rates are likely to slow growth in 2014 and the Fed’s eventual tapering of QE risks further capital flight and problems for the heavily-indebted public and private sectors.

Though China has been able to engineer a soft landing, other emerging economies like India and Brazil could face a lose-lose situation. They can either raise rates to defend currencies and stop outflows, risking a credit crunch, or let inflation run higher and face a cost of living crisis.

Europe looks far more stable. Though inflation will remain below 1 per cent, the eurozone should avoid falling into deflation and is set to grow around 1 per cent next year - most likely led by Germany in core Europe and Spain in the periphery.

There are risks. Complacency is the greatest of these – from investors, corporates and governments. Investors may again look at complex leveraged products such as “cov-lite” loans, pay-in-kind bonds and hybrid structures. Corporates in core countries may start to releverage themselves.

Governments, meanwhile, may be tempted to slow the pace of reform and relax spending controls as growth improves. Though the likes of Greece and Portugal have substantially cut labour costs and are seeing exports bounce back, Italy and France are lagging in making their own reforms.

Italy has failed to tackle its outmoded labour market and pension system, has one of Europe’s slowest judicial systems and, unlike Spain, has not reformed its highly-fragmented banking sector. France has its own inefficient labour market and excessive public spending. The government has only scraped the surface on pension reform.

It is unlikely any of the economies will thrive while lending to business continues to contract as a result of further bank deleveraging.

Bank lending accounts for approximately 90 per cent of credit to the European economy. Reviving it will be the ECB’s most important task in 2014. The situation appears to be improving. The pace of bank asset sales and loan-book shrinkage is slowing: banks cut EUR30 billion of assets in October, down from EUR 300-400 billion earlier in the year.

To properly address deleveraging, the ECB’s bank stress test and asset quality review

(AQR) will be crucial. The exercise, finishing in November 2014, could require as many as 20 of the 130 large eurozone banks to raise more capital. However, most of these banks are small and not systemically important.

By introducing greater harmonisation and transparency, and forcing weaker institutions to raise capital, the positives far outweigh any short-term negatives.

Fixing the banks won’t happen overnight. Policymakers need to find other ways to plug a EUR308 billion lending hole to European firms. The answer is neither another rate cut nor another long-term refinancing operation (LTRO) – though both are likely next year. Better still would be to increase public and private sources of alternative lending. That is why greater high-yield bond issuance, more securitisations and beefed up EIB programmes to support small and medium enterprises are so welcome. Together they will go a long way to closing Europe’s debilitating lending gap.


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