Credit investors see opportunities among Europe's banks, which offer attractive long-term plays versus other asset classes despite doubts over the rigor of stress tests on the sector.
Investors say tougher regulation on banks after the credit crisis and more robust capital requirements will make banks a safer option for credit investors.
"We think banks are cheap at current levels. Their credit spreads further away from their historical averages than other sectors," said Theodore Stamos, co-head of credit at Investec.
"In the longer term, banks will be safer and healthier and this is not reflected in where they are trading now."
Because of the financial crisis, only the strongest banks have been able to sell bonds to investors on a regular basis with weaker institutions reliant upon the European Central Bank for funding.
Many bank bonds are at bargain-basement levels and do not fully reflect balance sheet repair that has already taken place since the credit crisis, partly because Europe's sovereign debt crisis has put the sector under pressure.
Banks have already raised about 300 billion euros ($387 billion) since the start of the credit crisis, including 34 banks taking 170 billion euros from governments.
"Credit is a better place to be than the equity market in the bank sector," said a senior debt capital markets financial institutions banker at a European bank.
Global regulators want banks to hold more capital to help them survive future shocks. Precise plans on how much more banks need are expected later this year.
"We think the bull case for banks is a long-term story of improving capital basis, more stable funding mixes and less risk-taking," said Andrew Sheets, credit analyst at Morgan Stanley.
"The long-term story seems best expressed by buying long-term bonds, which currently discount no reduction in borrowing premium over the next 5, 10 or even 20 years," he said.
Sheets said, for example, that bonds of UK banks Royal Bank of Scotland and Lloyds are currently priced to yield about 3 percent more than U.K. gilts every year until 2018.
The possibility of a double-dip recession and uncertainty over banks' exposure to government bonds of heavily-indebted eurozone countries such as Greece, Portugal and Spain, has overshadowed the European bank sector for months.
This has forced banks to pay investors more to buy their bonds, and made it tough for many banks from southern Europe to access the bond markets.
Spanish bank BBVA, for example, managed to raise 2 billion euros via a covered bond on July 19, but had to pay a spread of 195 basis points over midswaps, the highest spread ever paid for a covered bond, bankers said.
The stress tests have shone some light on European bank exposures to government bonds, which may improve confidence. If more investors' warm toward financials this could help banks meet some of their hefty funding needs over the next three years, when they need to refinance more than $1 trillion in bonds, according to Thomson Reuters data.
Investors are already wary of a tide of new senior bond issuance from the banks if funding markets do thaw out.
"We would be hesitant to be overweight in senior bank bonds because there is likely to be a big wall of issuance over the next 24 months," said Stamos.
"We prefer Tier 1 bonds. These have rallied into the stress tests. There is also a potential to see more tenders and buy-backs. We haven't seen too much of these recently, but it's still advantageous to do them."
Investors can stand to make money by buying Tier 1 bonds on hopes that the issuing bank might offer to buy-them back at a premium.
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