One of the top economists at Credit Suisse has recently reiterated the bank’s advice to cautious investors that they should avoid certain types of European bank debt.

One of the top economists at Credit Suisse has recently reiterated the bank’s advice to cautious investors that they should avoid senior unsecured bank due to expected post-crisis rules about bank “bail-ins”.

The European Union has proposed rules allowing the “bail-in” of senior unsecured debt, requiring numerous banks to increase their buffers of capital affected by the rule change. A “bail-in” is, according to one definition, a step requiring holders of certain types of bond to forfeit part of an investment to "bail in" a bank before taxpayers are called up on to bail it out. Such “bail-ins” are considered a way to reduce the potential hit to taxpayers in the event of future government rescues. The proposal could come into force under the Resolution and Recovery Directive which, subject to the parliamentary timetable in Europe, could come into law as soon as January 2015.

Giles Keating, head of research and deputy global chief investment officer, speaking at a recent Credit Suisse conference on the firm’s economic outlook, explained that the bail-in idea should give investors holding senior unsecured bank debt reasons to look elsewhere - in the banking but also in the corporate space.

The proposed EU rules will allow the bail-in of senior unsecured debt, with at least 8 per cent of total liabilities in bail-inable equity, tier 1 and tier 2 debt targeted by 2018, he said.

“Numerous banks under our [Credit Suisse] coverage universe still need to build up buffers of bail-inable securities,” he said. He pointed out that comparable rules apply for Swiss and UK banks already.

The issue highlights how, after the tax-funded rescues of major banking groups after the 2008 credit crunch, policymakers are trying to ensure the costs of future bank rescues is spread more fairly, and reduce the “moral hazard” problem of bailing out banks with public funds. Meanwhile, analysts at PricewaterhouseCoopers have recently argued that European banks still need to issue as much as €180 billion ($247 billion) in fresh capital to plug funding gaps.

In late October, Credit Suisse listed the potential impact of the bail-in idea, pointing out that to date, holders of senior unsecured debt have not faced such a potential forfeit of capital in the event of a bank rescue.

“The upcoming EU-wide regulations for resolving failing banks could have profound effects for fixed income investors over the next three to five years,” the bank said in a note.

The bank said it is currently underweight senior unsecured bonds “for the time being”, and suggests that conservative investors should favour leading retail and commercial banks such as HSBC, Lloyds and Rabobank, while more risk-tolerant investors should consider Italian and Spanish banks, such as BBVA, Unicredit and Intesa. Credit Suisse continues to favour new issues of contingent convertible bonds.

Investment stance

Turning to its broader investment stance and economic outlook, Credit Suisse expects lower, but still-positive equity returns next year. Within the equity space, the bank prefers cyclical sectors and European equities.

On the fixed income side, the bank favours short-duration selected credits, taking the view that the best of bond market performance is now over. The most successful bond market areas in 2014 will most likely be in “frontier” segments such as low-investment grade paper, subordinated bank debt, and corporate hybrids.

As far as hedge funds are concerned, the Zurich-listed bank said it favours directional strategies. Among other “alternatives”, the bank is wary of commodities and property as they both suffer from rising real yields.