2 Winners From ‘Easy Money’ In Europe
The European Central Bank (ECB) has finally joined the global bond-buying party with its 19-month program to inject more than $1.2 trillion into the region. The program calls for the central bank’s monthly purchase of more than $60 billion of sovereign bonds along with asset-backed and agency debt.
#-ad_banner-#The new buying program could have some unforeseen consequences. Liquidity in sovereign bonds has already been a global concern, as evidenced by a 70% decrease in the amount of 10-year U.S. Treasury notes available to buy or sell over the last year. With the ECB program buying up European bonds, that same liquidity problem could hit the eurozone.
For example, a lack of liquidity in Italian bonds has already caused transaction costs to rise. In fact, the volume of futures contracts has surged 800% since 2009, as investors use derivatives to take a position that they can’t get in the bond market.
The new competition in bonds pushed the average yield to maturity of eurozone government debt to 0.538% in late February, the lowest since at least 1995 (when Bank of America started tracking this rate index).
Weak economic growth in Europe, coupled with the ECB’s bond buying, has driven interest rates to historic lows. While rates in the United States have fallen as well, the yield on 10-year European sovereign bonds sank more quickly.
Rates on the German 10-year, for example, have fallen 1.26 percentage points in the past year, twice the interest rate decline seen in equivalent U.S. bonds. The U.S. government now offers a 1.95% interest rate on its 10-year bonds. In Spain, where economic risks are arguably greater, 10-year bonds yield just 1.17%.
Companies Already Positioning In Euro Bonds
In response to ultra-low rates, companies are stepping up their rate of bond issuance, which set a record in 2014 and will likely set another record this year. The average yield on corporate investment grade bonds is just 2.1%, on par with yields on the 10-year U.S. Treasury.
The Coca-Cola Co. (NYSE: KO) joined a developing bond frenzy recently with $9.5 billion of two-to-20-year bonds at an average yield of just 0.89%, the lowest on record. The bonds follow a EUR 3 billion ($3.7 billion) issue of notes by Verizon Communications, Inc. (NYSE: VZ) and EUR 1.4 billion ($1.7 billion) in notes by Apple, Inc. (Nasdaq: AAPL) last year.
Not only are bond issues taking off, but the surge in the dollar means that there has rarely been a cheaper time to buy European assets. Record amounts of cash trapped overseas by U.S. companies could be combined with money from bond issues to make acquisitions in the region.
How To Position Your Portfolio
Record bond issuance and the potential for a strong mergers and acquisitions (M&A) market should provide a nice operating tailwind for major investment banks. While some U.S. banks will benefit from increased underwriting activity, the best plays are likely to be in select European banks, where weak economic growth has restrained valuations.
Deutsche Bank AG (NYSE: DB) is the largest bank in Germany and among the top five largest European banks. The bank’s American Depositary Receipts (ADRs) have fallen more than 20% over the last year on weak regional economic growth. The ADRs trade for just 0.59 times book value. This is well under the average multiple of 1.1 times book value of the four largest U.S. banks.
A EUR 8.5 billion capital raise last year significantly improved the bank’s Tier 1 equity ratio to 11.5%, a percentage point above the requirements by Basel III. I am not worried about recent stress tests by the Federal Reserve. Shares pay a 2.8% yield and are 12% below my $38.80 per share target, which is based on 0.7 times book value.
Barclays Plc (NYSE: BCS) is headquartered in London, but should still benefit from fixed-income and M&A activity in the European Union. Shares hold clear value at just 0.69 times book value.
The bank is in the midst of a restructuring process that should provide greater exposure to higher margin businesses. That should start to boost profit levels over the next few quarters. Shares pay a 5.8% yield and are 13% below my $17.50 per share target, which is based on 0.8 times book value.
Risks To Consider: Easy money does not necessarily translate into economic growth and share price appreciation. Indeed these banks will truly benefit when Europe is on the mend. The solid dividends generated by these banks provide incentive to hold shares into the recovery
Action To Take –> Get ahead of the developing bond and buyout bonanza in Europe by taking a position in two of the region’s largest investment banks.
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