The benefit of Basel III on Financial Bonds

The profitability of the banking sector is back in the news with another flurry of dramatic headlines around Deutsche Bank.

But it is important to be clear that there is a difference between profitability and solvency. Our investment approach is focused first on the safety and stability of the companies we invest in, followed second by a focus on profitability.

Our job as fixed income managers is to buy the bonds of strong companies and lock in long-term coupon payments to secure returns for our investors. Hence, we will use the current volatility in markets to pick up top-quality issues at discounted prices should there be indiscriminate selling. Additionally, most of our banks are UK-based, where the banking sector is much stronger than in Continental Europe, and we remain extremely selective.

That being said, the European sector has strengthened considerably in recent years, with a huge amount of capital now held under Basel III regulations. With this new stability, even if one institution suffers, it should not trigger sell-offs and defaults across the system as it has done historically.

Recently, results have been positive for most of our companies. Lloyds announced underlying profits of GBP 4.1 billion, showing healthy ongoing business (even if statutory profits after litigation costs and restructuring costs reduced that to GBP 2.5 billion), and a net interest margin of 2.7% and a return on equity for underlying profits of 14%. Elsewhere, Clydesdale Bank recently issued a 5.0% tier II bond that we bought a small quantity of, alongside a very small allocation of its 8% CoCo (contingent convertible bond). Outside of financials, the trading companies Louis Dreyfus and Glencore both published satisfactory results.

We are frequently asked what will happen when interest rates go up. We are managing our portfolios to try to be relatively insensitive to interest rate changes by holding about half of our fund in fixed rate bonds and half in fixed to floaters and floating rate notes.

Jeremy Smouha – manager – GAM Star Credit Opportunities