CS: Classic portfolio – July update

– For risk-averse buy-and-hold single bond investors looking for fresh buying opportunities, we present our new investment ideas for the month…..

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– Despite the recent rise in yields from the historical lows, most pronounced in the USD, benchmark yields generally remain at low levels. Investment-grade bonds in many cases offer only minimal returns, but better than cash as we expect.
– Nonetheless, we select fundamentally well-positioned corporate and senior bank bond issuers that offer a reasonable risk/reward proposition.

Classic Portfolio – July update
Since our June update, benchmark yields have moved slightly higher before stabilizing around the 2.5% level in the case of the all-important 10-year US Treasury. Efforts by central bankers to calm the markets, effectively allaying market concerns about the pace of scaling back expansionary monetary policy, has driven the stabilization. Lower volatility in benchmark yields has enabled credit spreads to retrace some of their earlier widening.
In this environment, we continue to look to the primary market for attractively priced bonds suitable for buy-and-hold investors.
Secondary market bonds generally offer poor liquidity and in many cases are priced far above par, making them relatively unattractive from a fiscal (tax) perspective for many investors.
For investors with higher risk tolerance and more ambitious total return expectations, we publish our trading-related bond investment ideas each week in the Research Weekly.

Classic portfolio additions/deletions
We drop two bonds in the USD portfolio (see Table for details, including the instances where we revise our recommendations from BUY to HOLD). We also previously revised the Fresenius 2.875% 07/20 in the EUR to HOLD from BUY, but retain it in the Classic Portfolio for the time being. Despite a relatively active new issue period since our last update, we actually find it quite difficult to identify low-risk bond investment ideas offering a reasonable return, especially on an inflation-adjusted basis.
Returns are likely to be better than what cash can offer, but that still leaves investors with minimal return payoff in highquality corporate bonds. Senior bank securities in many cases still offer a degree of yield pick-up that we find relatively attractive, though we look to strongly positioned banks when adding new bank bonds to the Classic Portfolio. We like the recent issues from the Bank of America, National Australia Bank and a seasoned bond from BNP, the latter trading significantly below par. We also add Imperial Tobacco in the USD, a name that we consider to be fundamentally well positioned in the stable consumer staples sector.
The chart below shows our colleagues’ sovereign duration recommendation ranges. As demonstrated by the rather extended duration recommendation for the Italian sovereign,  when credit spreads are significant, the higher carry, or even the expected spread contraction, can result in positive total return expectations and outweigh any duration concerns.

Issuer comments
In the following section, we highlight key characteristics of the issuers that we are adding to the Classic Portfolio. Full credit profiles of all issuers we recommend can be found over the relevant Global Research platforms or by contacting your Credit Suisse relationship manager. (30/07/2013)

Imperial Tobacco (S&P: BBB, Stable / Moody’s: Baa3, Positive / Fitch: BBB, Stable)
– The UK-based Imperial Tobacco is the world’s fourth largest international tobacco company behind Philip Morris International, British American Tobacco and Japan Tobacco. Its cigarette portfolio includes brands such as Davidoff, West and JP Sand Gauloises, and is complemented by its world leading position in cigars, fine-cut tobacco and rolling paper products. Imperial tobacco’s businesses are geographically well diversified with operations in more than 160 countries.
– The tobacco business is highly regulated, but still produces superior margins and operating cash flows in the corporate space. The adjusted EBITDA margin of around 23%, albeit strong, is somewhat below peers. The industry outlook is for a continued slow decline in volumes, primarily in mature markets.
We expect regulatory pressure to continue. Nonetheless, cigarette manufacturers retain a level of pricing power that supports operating margins and largely compensates for lost revenues due to declining volumes. The company remains in a comfortable position to produce returns well above its cost of capital.
– We have a Stable fundamental credit view on Imperial Tobacco and think that the recent shift higher in benchmark yields provides an interesting entry level for a solid mid BBB credit.
We also note that the bond has a step-up provision. In an unlikely event that credit ratings fall below investment grade by S&P or Moody’s, the coupon would step up by 125 bp.

National Australia Bank (S&P: AA-, Stable / Moody’s: Aa2, Stable / Fitch: AA-, Stable)
– National Australia Bank Limited (NAB) is one of the four largest banks in Australia (18% share of the domestic banking system) and also the fourth largest bank in New Zealand with an 18% market share. It operates through its international subsidiaries across Europe, Asia and the USA. It is organized in nine segments, offering retail and investment banking, as well as wealth management and insurance services and products.
In addition, NAB has strong presence in the corporate and agricultural banking sector in its home markets.
– NAB’s fundamentals are characterized by satisfactory profitability and solid capitalization. The bank has managed to increase its pre-tax ROE to 17.0% in H1 2013, nearly 3 pp higher vs. year-end 2012, though still lagging peers. Its focus
on cost reduction has offset the lower net interest margin which remains still at satisfactory levels. Asset quality is solid,
with stable growth in lending and a loan book which is less risk-sensitive than in the previous years. Funding, traditionally the weakest spot due to Australian banks’ traditional reliance on wholesale funding for structural reasons, has considerably improved, not only for NAB but also for its peers. NAB’s capi- talization is solid and in line with its peers, reporting a common equity tier 1 ratio of 8.2% vs. 7.9% at end-September 2012.
– We view the recently issued NAB 2.3% 07/18 senior bond in the USD, priced at 100.03% and yielding 2.29% to maturity, as a defensive investment, supported by the issuer’s robust credit profile.

BNP Paribas (S&P: A+, Negative / Moody’s: A2, Stable / Fitch: A+, Stable)
– BNP Paribas S.A. (BNP) is the largest bank in France and one of the world’s largest banking groups with nearly EUR 2 trn of assets as of 31 March 2013. The bank’s universal business model comprises three core areas: Retail Banking, Corporate and Investment Banking, and Investment Solutions. In addition to France, BNP has retail operations in Italy (BNL), Belgium and Luxembourg (Fortis), the USA (BancWest), Eastern Europe (Poland, Ukraine), and the Mediterranean basin (Turkey, Gulf region).
– Large-scale, broad diversification and sustainable strong operating performance underpin BNP’s business profile. French retail is a solid and stable performance contributor (contributing approx. 21% of pre-tax income in 2012), though BNP ranks only fifth (based on total revenues) in its home market.
While the more volatile investment banking accounts for a large share of operations, BNP has a broad franchise with strong expertise, enabling it to benefit from various market developments.
Its trading book is sizeable, though the track record in risk management is good.
– We regard BNP Paribas as the strongest French bank, based on its superior profitability and business franchise which performs solidly in various market environments and ranges well ahead of domestic peers. BNP is also leading in terms of capitalization: The Basel 3 common equity tier 1 ratio of above 10% as of 31 March 2013 makes it a leader among French peers. We thus continue to have a Stable fundamental credit view on BNP, reflecting its better credit quality versus French peers. BNP’s sizeable trading book and large exposure to Italy via BNL are the main potential vulnerabilities, which could materialize in the event of a renewed escalation of the peripheral European debt crisis and/or a major market dislocation.
– The BNP 3.25% 03/23 in the USD offers a yield of above 4%, which we consider as attractive. However, investors need to be aware of the high sensitivity of this bond to changes in the long-term US Treasury rates due to its long maturity (i.e., high modified duration). We expect BNP’s credit spreads to remain relatively stable in coming months in light of the issuer’s solid credit profile. Moreover, CSinterest rates strategists forecast 10-year US Treasury yields of 2.3% (currently 2.5%) in the 12-month horizon. Both points bode well for the performance of this bond. Nevertheless, a further increase in longterm US government benchmark yields cannot be excluded, which represents a major downside risk.

Bank of America (S&P: A-, Negative / Moody’s: Baa2, Negative / Fitch: A, Stable)
– Bank of America Corporation (BAC) is a US bank with the largest domestic deposit market share. Its retail network covers about 80% of the US population. It is a universal bank, well diversified by products and geography. It gained a leading market position in wealth management, trading, corporate and investment banking globally after acquiring Countywide (in 2008) and Merrill Lynch (in 2009). Outside the USA, it focuses mainly on corporate and investment banking, capital markets and the wealth management business.
– Bank of America’s Q2 2013 results reflected generally improving credit metrics. Its bottom-line earnings benefited from solid results in wealth management as well as global banking, due to a very low level of provisions related to legacy assets.
Asset quality continued to improve, enabling a reserve release of USD 0.9 bn, as well as an increase in the reserve coverage.
The favorable housing market trend is leading to lower mortgage delinquencies. Litigation expenses and provisions for mortgage repurchase claims were slightly above USD 600 m, declining versus the previous quarters. The issuers’ liquidity profile continued to be its strength, with excess liquidity above USD 340 bn, equal to 10% of total unsecured long-term debt.
Capitalization grew further, with the common equity ratio at 10.8% (Basel I), vs. 10.3% in the previous quarter.
– The recommended BAC 2.4% 07/20 senior bond in the EUR is priced at 99.21% at the time of writing, yielding 2.63% to maturity. We view this yield as offering an adequate return, considering the issuer’s strong market position and strengthening fundamentals.

Source: BONDWorld – Credit Suisse