15th June 2012

Fidelity's Ian Spreadbury comments on Mansion House speeches

Speeches by Chancellor Osborne and Bank of England (‘BoE’) Governor King have revealed two new direct credit easing measures coming into effect in the UK:

1) A “funding for lending” scheme to provide cheap funding for banks for up to 3-4 years at below market rates which is conditional on the funds being on-lent to businesses and households, and;

2) Activation of the Extended Collateral Term Repo Facility (a UK-style LTRO), that provides 6 month liquidity against a wide range of accepted collateral, with at least £5bn per month made available. This scheme was initially set-up in December 2011.

These measures are recognition that the BoE’s asset purchase scheme alone is not enough to stimulate the ailing UK economy, although the Governor also hinted at the possibility of expanding the scheme beyond its current £325 billion limit.

The market reaction was predictable; Gilt yields have fallen across the curve and equity markets are up, with banks outperforming.

Ian Spreadbury, Portfolio Manager, Fidelity Strategic Bond Fund, comments: “Conventional monetary policy is impotent against the deflationary forces of deleveraging in the UK economy and the efficacy of unconventional quantitative easing is questionable. These more targeted measures could have more of an impact, but I don’t expect too much. The serious problems of indebtedness and the Euro zone crisis are still with us and there is not much the Bank can do to solve them.

“My concern as a bond investor is that as gilt yields grind lower, the risks become more asymmetric. They may well stay low for sometime but at these levels I’m thinking about protecting the price downside caused by an eventual increase in yields. Without an improvement in growth it also makes sense to keep a defensive stance when investing in corporate bonds. Despite strong company fundamentals, this market is not immune to the weakening macro backdrop.”

The Governor’s speech also set out the BoE’s approach to prudential supervision which will have implications for bank bonds. This followed the release of a White Paper on banking reform from the Treasury yesterday. The main thrust of the announcements is consistent with the recommendations laid out in last year’s report from the Independent Commission on Banking (‘ICB’). So there was no new bad news for bondholders.

The key political message was that there will be no extra gold plating for UK banks, aimed at supporting their international competitiveness. The UK will move in line with Europe. The key points are:

• ·         The Banking Act will come this Parliament (i.e. in or before 2015) and will be enforced from 2019
• ·         UK banks will have to maintain a 17% total capital ratio - about 5% higher than theBasel 3 requirement
• ·         Depositors will be given full preference in the event of a bank failure. This is the largest negative for bondholders, given they will be pushed down the capital structure
• ·         The UK will become the first EU country to adopt a leverage ratio
• ·         Retail operations will have to be “ring-fenced” from riskier parts of the bank. Although banks have been given greater flexibility than first recommended by the ICB report
• ·         Key for bondholders is the level of funding flexibility banks will be given with regard to the different parts under the “ring-fencing” proposal. This has been left open in the White Paper, so the reaction of ratings agencies is still not clear

Perhaps the most interesting point for banks from yesterday’s announcements was the Governor’s reiteration that central banks stand ready to provide extraordinary amounts of liquidity to the financial system. He said this meant “the need for banks to hold large liquid asset buffers is much diminished”. This subtle reference suggests concern over the tendency for banks to rely on domestic government bonds for their safety buffers. The Governor is clearly worried about the strong and growing links between sovereign stress and the banking system.

Ian Spreadbury comments: “There is nothing new from the banking reform announcements to change my view on the sector. Senior bank bonds are essentially less secure for bondholders than they were in the past – they will be subordinated to deposit holders – so I continue to limit my exposure in this area.

"Lower down in the capital structure the risk of being bailed in has been clear for some time and I do think you’re getting paid for that risk. However, for bond investors that value a low volatility of returns and a secure income, I don’t think it is sensible become over-exposed to subordinated bank paper.

"My main concern remains the link between sovereign and bank. The structural problems effecting the UK and Europe are not going to be solved any time soon, which means sovereign credit quality will continue to decline. Banks will suffer directly through their holdings of government debt, but also indirectly through wider market stress. That means we can assume the yields on bank bonds will remain higher than corporates. It also means the market for bank bonds will remain volatile and subject to periods of illiquidity.”

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