Simon Chester—whose responsibilities as vice president and portfolio manager on the international fixed income team at American Century Investments^® are focused on non-U.S. credit securities—provides his team’s assessment of European bank credits as the European sovereign debt crisis and global economic slowdown continue to put pressure on the financial sector.

On the surface, the European banking sector’s status in the fixed-income markets should be on the upswing. After the near-collapse of the financial system during the 2008 Financial Crisis, members from the world’s largest central banks gathered to address shortcomings in financial regulation that came to light in the crisis. The regulatory framework that came out of this meeting, known as the Basel III Accord, strengthened capital requirements for banks and also set stricter guidelines for liquidity and debt. All of these factors help reduce the risk profile of the banking sector, and this would normally be attractive to fixed-income investors.

However, bond investors have had the opposite reaction, shunning the bonds of European banks in recent months. As the accompanying chart shows, the spread (or gap) between the yields of European bank bonds and government bonds recently rose to levels not seen since the height of the 2008 Financial Crisis.

Several factors have contributed to these wider yield spreads:

 

• Sovereign debt exposure: The sovereign debt crisis in Europe—which has already led to the bailouts of Greece, Ireland, and Portugal by the European Union (EU)—has worsened in the past several months, with a second bailout for Greece going through the approval process and amid growing concerns about fiscal conditions in Spain and Italy. According to an estimate from the International Monetary Fund (IMF), European banks potentially face $400 billion in losses from the eurozone debt crisis.
• Bailout uncertainty: Some fiscally stronger nations in Europe have expressed some dissatisfaction with their role in contributing to the financial aid packages for fiscally troubled countries, creating some uncertainty about future EU financial support if the debt crisis worsens.
• Global economic downturn: Weaker economic conditions in many developed countries, including the U.S., have led to anxiety about a possible global recession.
• Challenges raising capital: As banks have lowered their risk profiles, the resulting lower returns on equity have made it harder for banks to raise capital in the stock market.

 

Our Take—A Measured Approach

At American Century Investments, our international fixed-income team has maintained a cautious approach to its European bank exposure. We believe the banking sector as a whole is robust enough to withstand foreseeable pressures on European debt, given the banks’ capital ratios and sovereign exposure levels. The Basel III accord requires banks to hold 6% of their assets (weighted by credit risk) in Tier 1 capital, which generally consists of the bank’s common stock and retained earnings. The 15 largest European banks all have Tier 1 capital ratios of 7% or more. In addition, their combined exposure to the sovereign debt of the three bailout countries is less than 5% of their overall risk-weighted assets.

However, we believe the political nature of the situation creates significant uncertainty, in part because austerity measures in Southern Europe and supportive actions from the rest of the Continent are deeply unpopular with the respective electorates. In addition, we think the spread of the crisis to larger, fiscally vulnerable countries—such as Italy and Spain—would cause more damage. Italy and Spain have surmountable fiscal challenges, in our view. But if these challenges are not met, the losses that these two larger nations would pose for the European banking sector appear substantial to us.

Another factor is investor sentiment and confidence. Both are critical elements for bank funding—it is difficult-to-impossible to access the capital markets for funding if potential investors lack confidence in your ability to make profits and repay your debts. Unfortunately, we think both investor sentiment and confidence are lacking in the current environment. If banks continue to struggle with raising capital in the financial markets in 2012, we believe weaker banks could face a liquidity squeeze that would put further pressure on the overall banking sector.

As a result, we have focused our modest investments in the European banking sector on diverse banking groups with a relatively low exposure to troubled sovereign debt. Examples include Credit Suisse and HSBC, whose debt values have fallen along with the rest of the sector due to broad contagion fears. However, we believe they have limited exposure to potential sovereign debt losses, so the declines have made their valuations attractive to us.

The Next Step—A United Fiscal Union

In our view, the key factor that would help restore confidence in the European banking sector is a coherent effort from central European authorities to unite the EU fiscally, thereby consolidating all eurozone government debt. It’s worth noting here that financial data indicates that, as a whole, the EU is in better fiscal shape than the U.S. We believe a single fiscal entity would make it much easier to withstand and overcome the current debt problems.

However, we don’t think that a single fiscal entity is likely to happen in the near term. Europe does not appear to have the political mandate to explicitly support consolidated sovereign debt. We anticipate a prolonged sovereign debt impasse. Meanwhile, we believe the fiscally struggling countries need time to implement austerity measures and build a credible path to meet their fiscal goals.

Put it all together, and we think sentiment toward the European banking sector should remain weak for some time. Nonetheless, we will remain vigilant in this sector, seeking to strike a balance between valuation opportunities to pursue and downside risks.

 

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information:  U.S Investment Professionals

Statements regarding specific holdings represent personal views and compensation has not been received in connection with such views.

This information is not intended to serve as investment advice; it is for educational purposes only.

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.

International investing involves special risks, such as political instability and currency fluctuations.

The opinions expressed are those of Simon Chester and the international fixed income portfolio management team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio.

 

 

 

 

(c) American Century Investments

www.americancentury.com

 

 

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