July 2011: CS: Fixed Income Recommendations

Fixed income model portfolio allocation
– Awaiting more clarity about further developments in Greece and signs of improvement in macroeconomic data we keep our neutral stance on duration, being market weight in segments with a long duration.
– We also keep a neutral positioning in risky credits, favoring investment grade industrials instead of high yield and emerging market bonds.
– As near term inflation risks are more contained, we are market weight inflation-linked bonds.

International comparison of sovereign debt metrics
For most countries, sovereign gross debt will exceed – in some cases significantly – 80% of GDP. This would see the AAA rating start to come under pressure, according to Fitch, if those levels are considered to be permanent.

Corporate bonds
– Strengthened balance sheets may be at risk of a growing shareholder focus, limiting further spread tightening potential in 2011.
– Peripheral sovereign turmoil is impacting domestic corporates (utilities and telecoms in particular), and threatens to fed through to corporate credit valuations.
– As we expect benchmark rates to move gradually higher in 2011, investors can find name specific opportunities
further down the credit curve to achieve higher returns.
– Risk averse investors: Focus on short to medium maturity bonds with low event risk in the A to BBB space.
– Risk tolerant investors: Selective opportunities in high yield*, EM corporate bonds and corporate hybrid bonds.
Top picks: BMW, Daimler, Honda, Toyota, Bayer (hybrid), Henkel (hybrid), Telefonica, Telecom Italia, Lafarge

High yield bond market
– The prospect of lower growth in the US and uncertainty surrounding Greek debt (and peripheral contagion) have recently pressured high yield returns. Spreads for US and European HY now stand at 565 bp and 587 bp, respectively.
– During recent quarters net leverage has trended upwards, though it still remains below the 10 year average (as measured since 1Q 2000).
– While we remain neutral on the asset class there are interesting name-specific opportunities which offer value and price appreciation potential.

Top picks: Continental, HeidelbergCement, MOL Hungarian Oil & Gas, Wind Telecomunicazioni

Corporate hybrid bonds
– Corporate hybrid bonds are securities which contain both debt and equity features.
– These bonds are interesting for risk-tolerant investors seeking additional yield.
– We have BUY recommendations on selected bonds from a limited corporate hybrid universe.
– The sector is correlated to bank Tier-1 securities. In combination with bank Tier-1 bonds corporate hybrid valuations have improved recently.
– We recommend that corporate hybrid bonds only constitute a small share of a well-diversified bond portfolio.

Corporate hybrid bonds
– Where investors are comfortable with a particular corporate credit, a switch from the senior into the
hybrid can be attractive.
– When compared to the last twelve month (LTM) range, the yield pickups currently are becoming more attractive compared to recent levels.
– We have BUY recommendations on the hybrids of Bayer, Linde, Henkel and Siemens.
– While upside potential is higher for weaker credits, clearly so are the risks.

Banks
– The EU peripheral turmoil has led to periodic volatility in banks’ valuations, particularly in subordinated bank debt, thus offering interesting investment opportunities.
– The changing regulatory landscape will remain a key theme in 2011. We think that Basel III changes are beneficial for banks’ credit quality.
– The changing regulatory environment will further emphasize the difference between the strong and the weak players.
– In this environment we reiterate our preference towards large, diversified, systemically important banks with a solid retail base; this is relevant for both senior and subordinated bank debt.
– Risk averse investors: BUY senior bonds from leading banks with systemic importance in their respective jurisdictions. BUY selective Lower Tier 2 bonds from most solid issuers.
– Risk tolerant investors: BUY selective Tier 1 bank debt from strong issuers.
Top picks: BNP, HSBC, Barclays, UBS, CBA, ANZ, NAB

Financial sector positioning
Senior debt: Market perform, refinancing needs look less onerous than we had been anticipating.
LT2: Market perform, as the lack of supply due to non-compliance to Basel III and the grandfathering process are supportive factors.
Tier 1: Outperform, valuations are cheap and perpetuals offer an interesting yield with the enhanced likelihood, due to the upcoming Basel III regulations, to be called on the first call date.

Sub-sovereign, supra-nationals and agencies
– With gradually increasing interest rates, supply pressures and an elevated volatility environment for sovereigns, we only see limited upside potential for the SSA sector and maintain it on underperform.
– Given weakening sovereign fiscal balances and supply expectations, we continue to favor issuers within the SSA sector, which are related to governments perceived as having the highest credit quality.
– For buy and hold investors, the SSA sector offers a yield pick-up vs. government bonds at a similar risk level.

Top picks: IBRD, KBN, NIB, NEDWBK

Inflation-linked bonds
– For buy-and-hold investors, ILBs continue to represent an interesting investment proposal as they offer explicit protection against loss of purchasing power due to inflation.
– Total return investors, however, will have to apply more caution towards ILBs going forward as we expect real yields to move higher, and as ILBs typically have long maturities.
Top picks: US Government (TSY Infl IX N/B) Germany (Bundesobligation I/L)

Emerging markets (EMs)
– Valuation (absolute yield basis) of many EM sovereign and EM corporate bonds is fair
– Prefer BBB and BB credits among EM corporates
– Selective investments in local currency bonds

Overweights
– Colombia

Marketweights
– Russia, Ukraine, Turkey, Brazil, Peru, Indonesia, Argentina, Venezuela, South Africa

Underweight
– Mexico, Philippines, Peru

Top picks

Sovereigns: Colombia
Corporates: Russian Agricultural Bank, Gazprom, Sberbank

Conviction calls
– Telefonica (A-/Baa1/A-) is among the most geographically diversified telecoms operators. With only 30% of group sales in its domestic market of Spain, we think peripheral sovereign risk has unfairly caused spreads to widen. Telefonica is one of our most preferred names in the Telecoms space.
– EBITDA margin is at upper end of the European industry average (42% versus 30-40% range). This supports cash flow generation.
– Target returns: We think the TELEFO 17s have scope to tighten inside Bund+150 from its Bunds+220 issue level, as we believe the name is geographically diversified enough to withstand peripheral concerns.
– Risk factors: During periods of sovereign-related volatility issuers perceived to have peripheral exposure will sell off.
BUY EUR TELEFO 4.75% 02/17

Conviction calls
– Bayer (BBB-/Baa3/BBB) is a well placed global chemical and life science company.
– Pharmaceutical and Crop Science are resilient operations providing stability, while the more cyclical Material Science
activities brings exposure to the economic recovery. Geographic diversification is good.
– Target returns: We expect the spreads of Bayer’s 5% 05- 15 hybrid to contract further with the group benefitting from
the economic recovery. While spreads appear more on the rich side on a one year horizon, they are still above precrisis
levels.
– Risk factors: A downgrade of Bayer’s “A–” senior rating would mean a downgrade to non-investment grade for the
hybrid instrument. This could cause some technical selling pressure in the hybrid as some investors may be forced
sellers.
BUY BAYNGR 5% hybrid in EUR call 07/15 for risk-tolerant investors

Conviction calls
– MOL Hungarian Oil & Gas (BB+/BBB-) is a mediumsized integrated oil and gas company based in Hungary with operations mainly in Central and Eastern Europe. MOL’s bonds have been pressured, excessively in our opinion, by Hungarian sovereign risk.
– We expect MOL to grow inline with rising oil and natural gas prices, heightened demand, operational improvements and regional GDP growth rates.
– Target returns: We expect the EUR 3.875% will tighten to Bunds + 250 bp, as MOL benefits from high oil prices, increasing international exposure and a modest domestic recovery. The bond is senior secured.
– Risk factors: MOL is exposed to volatile refining and cyclical petrochemical markets, Hungarian sovereign uncertainties, EM exploration activities, M&A risk and political maneuvering in Croatia.
BUY EUR MOLHB 3.875% 10/15 for risk-tolerant investors

Conviction calls
– Wind Telecomunicazioni (Ba2/BB/BB+) is an integrated telecommunications operator based in Italy, offering mobile, internet, fixed-line voice and broadband internet services. Wind has recently been acquired by VimpelCom of Russia, which we view as a credit positive (ie, stronger shareholder).
– We expect Wind to continue producing consistent results, with modest sales and margin expansion, despite pressure from Italian sovereign concerns.
– Target returns: We believe the EUR 7.375% has an attractive YTC of 8.7% with price upside to the 105.5 call in 11/2013. The bonds is senior secured.
– Risk factors: The Italian market is competitive and mature. Italian sovereign issues and potential M&A actions have recently pressured the bond.
BUY WINDIM EUR 7.375% 02/2018 bond for risk-tolerant investors

Conviction calls
– Swissport International (ticker: AGUILA, rating: B2/B) is the world’s largest independent airport ground handler and is well-positioned geographically with a diverse customer base. The company was acquired by the equity sponsor PAI in late 2010 and has since issued bonds in CHF and USD.
– We expect above-GDP expansion in revenues and EBITDA over the next 2 years, with the company benefitting from industry growth and the trend towards increased airport outsourcing, despite pressure on airline performance due to rising oil prices.
– Target returns: Swissport has the scope to tighten inside Swiss + 580 bp with further upside limited by the call schedule which starts at 105.9 in 01/2014.
– Risk factors: Swissport is exposed to the cyclical airline industry and is highly leveraged.
BUY CHF Swissport (AGUILA) 7.875% 01/18 for risk-tolerant investors

Conviction calls
– HeidelbergCement (Ba2/BB/BB+) has a strong position in the global heavy building materials industry, has good geographic diversification, has tapped shareholders for fresh capital to reduce debt, and termed out much of its short term debt.
– We expect a gradual improvement in earnings and cash flows over the next 18 months, which we believe will lead to higher agency credit ratings.
– Target returns: We think the HEIGR 15s have scope to tighten well inside of Bunds+200, as credit metrics and ratings
improve back towards low IG.
– Risk factors: Government austerity efforts will dampen spending on public infrastructure projects. It is possible that
such curtailments delay the recovery in earnings and cash flows that are necessary to boost both credit metrics and ratings.
BUY EUR HEIGR 6.5% 08/15 for risk-tolerant investors

Conviction calls
– Lafarge (BB+/Baa3/BBB-) is a global heavy building materials company. Since its Orascom Cement acquisition in 2008 it has struggled to restore financial metrics to levels in line with IG, leading to S&P to downgrade the company to BB+ recently (outlook stable).
– We expect credit metrics to improve in 2011 based on the debt reduction target of EUR 2 bn and gradually improving end markets.
– Target returns: We believe the LGFP EUR ’15s have scope to tighten well inside Bund+200 bp level.
– Risk factors: Lafarge has substantial exposure to the Africa/Middle East region, making the company vulnerable to extended disruption of the area’s building & construction markets.
BUY LGFP 6.125% 05/15 for risk-tolerant investors

Conviction calls
– BNP (AA, Neg/Aa2, Watch Neg./AA-, Stb) is one of the largest and most diversified banks with a strong position in retail, corporate, investment banking and asset management.
– BNP performs strongly in a challenging operating environment, the integration of Fortis progresses well and we regard its exposure to weaker sovereigns as manageable.
– Target returns: We envisage a further tightening potential of BNP’s 5.186% USD Tier 1, with the market increasingly pricing in a call on the first call date in 2015, given BNP’s strong track record and high ratings.
– Risk factors: As a deeply subordinated instrument, bank’s Tier 1 bonds are prone to market volatility, especially when
related to the European sovereign debt crisis.

Conviction calls
– UBS (A1, Stb/Aa3, Neg/A+, Stb) is a diversified financial services firm with a strong wealth management franchise.
– UBS reported a relatively solid set of FY 2010 results, reflecting the continued tough environment for the Investment Bank division, but somewhat improving market activity in Wealth Management. 1Q 2011 saw an encouraging net new money inflow, suggesting confidence in the institution is returning.
– Target returns: We expect the UBS 4.28% EUR Tier 1 to continue to display a strong performance, supported by the bank’s track record in calling its innovative Tier 1 perpetual instruments on the first call date.
– Risk factors: The investment bank division is struggling to gain traction and revenues continue to come in substantially behind the bank’s medium-term targets.
BUY UBS 4.28% Tier 1 in EUR call 04/15 for risk-tolerant investors

Conviction calls
HSBC (AA-, Stb/Aa2, Neg/AA, Stb) is one of the top financial service groups in the world, both according to geographic and product diversification. It enjoys solid fundamentals and a prudent risk profile.
– FY 2010 results reflected a net income of USD 13.2 bn as well as robust credit metrics. HSBC maintains a very strong market position, which together with its solid fundamentals enabled it to overcome the financial crisis unscathed.
– Target returns: We expect limited price appreciation on the HSBC 5.3687% EUR Tier 1 as the market is pricing in the call in 2014. This bond offers an interesting yield, given its stable performance and track record of calling hybrid bonds on the first call date.
– Risk factors: HSBC has minor exposure to EU peripheral countries, which could, in times of negative sentiment, heighten volatility on the sub-debt instruments.
BUY HSBC 5.3687% Tier 1 in EUR call 03/14 for risk-tolerant investors

Conviction calls – trade rescission
– We rescinded the SOCGEN 4.196% Tier 1 late June following rising concerns abut bank exposure to Greek banks.
– We continue to have a buy on the bond but prefer to adopt a more cautious stance and would currently not include the bond among our conviction calls.
– We rescinded the ACAFP 6.637% Tier 1 late June following rising concerns about the bank’s exposure to Greek banks.
– We continue to have a buy on the bond but prefer to adopt a more cautious stance and would currently not include the bond among our conviction calls.

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