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Finding Safety in Italian Fixed Income

18 October 2016 by Ben Hayward

Several conversations I have had with investors recently have touched on our Italian Asset Backed Securities (ABS) exposure. Understandably the situation many Italian banks find themselves in is a cause for concern.

So how do we get comfortable with our Italian ABS in this environment?

The problem that Italian banks are facing is to do with the quality of assets on their balance sheet and the impact that would have on capital. Having a high degree of non-performing assets on their balance sheet is calling into question whether the value they are being carried at reflects their quality and whether the banks would have the minimum regulatory capital after any appropriate adjustment takes place to account for the real value.

Does the health of Italian banks directly affect their securitisations and can the same questions of capital and asset quality be asked of their securitisations?

The first issue directly addresses one of the big benefits of securitisations. Unlike all other debt instruments (covered bonds, senior debt, Lower Tier II etc.) which are issued by the bank, the securitisation is issued by a Special Purpose Vehicle (SPV), meaning that the ABS/RMBS bonds are bankruptcy remote. In other words they cannot be bailed in to any restructuring, and they are secured on the asset pool rather than the general balance sheet (which is what got the banks into trouble in the first place)  – for the effectiveness of this I refer you to the solvency issues suffered by Northern Rock, SNS Bank, Co-op Bank etc. Suffice to say that Co-op covered bonds were downgraded from AAA to BBB (everything else went to non-investment grade rated) but the securitisations retained their AAA rating. The price impact was similarly muted in their RMBS deals by comparison.

What about the asset quality vs capital?

The first thing to state here is that we have much better information about asset quality than any investor who is buying bank bonds or equity. Why? The reporting we get for our deals sets out how many of the underlying loans in our deal are up to date on payments, how many aren’t, and how many are in long-term arrears and therefore showing proper sign of stress (i.e. may become Non-Performing Loans) as well as a vast amount of other relevant information such as loan to value, terms and conditions of the loans and so on. We know that these assets are performing well, and within our expectations.

So what about capital?

Well as I said above these are not bonds issued by banks, so they are not subject to the same regulatory capital requirements that banks are. However instead of the concept of complicated capital weightings, and different tiers of capital, we can look at our equivalent. Each transaction will assume that borrowers may miss coupons and default on their obligations, leading to the potential for income and principal hits being taken. To that end the issuers structure (and we subsequently review) a “loss cushion” for bondholders. This will be made up from excess profit in the deal (the net margin between the yield on the assets and the interest on the bonds), and the reserve fund/junior bonds held by the originating bank and other investors. This is a simple calculation, and can be easily measured against current NPLs, enabling us to calculate how many NPLs/defaults and losses we need to eat through this capital buffer.

A good example of the capital vs asset quality is SIENA 2010-7 A3. This is a bond from Monte Paschi di Siena, probably the most stressed of Italian banks, which has only 1.37% of loans in long-term arrears, but which has a whopping 42.79% loss cushion. I am sure any bank investor would love to have CET1 capital at 43% and with a strong performing loan book.

However we also have to bear in mind that the issues that banks are experiencing are related to their exposure to their corporate lending book, not their loans to consumers.

So where Italian bank bond investors are suffering from lack of transparency, poor asset quality and uncertainty on real capital levels, we can relax knowing that we don’t share those problems, and can enjoy particularly attractive returns at the same time.

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