Fear of the unknown ends rally in bank shares

This week’s wobble in bank share prices has highlighted the risks that remain in the financials sector, in spite of its strong rally this year, professional investors warn.

Financial stocks around the world slumped on Thursday after it emerged that the government in Dubai might default on interest payments on some of its bonds, and fears grew over UK banks’ exposure to the region.

These price falls followed a strong bull period for the banks. Until Wednesday, Barclays’ shares had risen 374 per cent from their low in March; Lloyds Banking Group’s shares had risen 173 per cent; and HSBC’s shares were up 132 per cent over the same period.

On Thursday, the three stocks fell by 5-8 per cent.

“Dubai highlights that there are a number of risks that people have slightly forgotten about that are going to rear their ugly head again,” warns Julian Chillingworth, chief investment officer at Rathbones. “There’s a huge amount of borrowing out there that needs to be deleveraged over the next few years.”

Fund managers say it is still difficult to find out just how much risk a bank has taken on. “There’s such lack of clarity over what these things are worth,” says Tom Becket at PSigma.

“Lloyds could be wildly overpriced or the best trading opportunity you’ll see in the next two years – there’s just no clarity on it at the moment.”

Investors are being advised that, because the sector is so complex, the best way to gain exposure to financial stocks is via a fund with an experienced manager. “It’s a minefield for private investors to navigate,” warns Adrian Lowcock at Bestinvest.

Jupiter’s Financial Opportunities fund, run by Philip Gibbs, is well regarded by fund analysts. It has just strengthened its investment team, hiring financial manager Guy de Blonay from Henderson New Star. As a result, it is considered to be the only financial fund worth considering by many analysts.

“Gibbs is so much ahead and, with Guy [de Blonay] joining him, I can’t see the point of going anywhere else,” says Mark Dampier, head of research at Hargreaves Lansdown.

Gibbs, himself, thinks that bank shares will rise further. “We believe it would be brave to be very underinvested against the background of current valuations,” he says.

He believes the financial sector is still cheap, pointing out that share prices are still about half their pre-credit crunch level. “We believe banks are the most liquid and desirable place to be invested to participate in the recovery,” he argues.

But many fund managers are unwilling to risk a call on financials. Neil Woodford, Invesco Perpetual’s star fund manager, says he avoids investing in any banks as they are so opaque.

Others simply avoid certain shares. Rathbones, PSigma and Royal London Asset Management (RLAM) are sticking to HSBC, Barclays and Standard Chartered – banks with overseas earnings that are not part government-owned.

Others believe that the best way to gain exposure to financials is through their bonds, rather than their shares. “We would much rather be playing our financials exposure through bank bonds than equities,” says Becket.

Lloyds received an enthusiastic take-up this week of its contingent convertible bonds – dubbed “CoCos”– having offered existing bondholders the option to swap into these instruments. The bonds offer more income security and come with a fixed maturity date.

Rathbones and RLAM both moved clients’ money into the CoCos. “It’s positive, generally, as it shows that, tentatively, these markets are opening up,” says Martin Foden, a credit analyst at RLAM.

Credit investors are also more willing to go down the risk scale. Earlier this year, bond fund managers were avoiding subordinated – or tier 1 – bank debt, as it ranks below other debt for repayment. But Foden has since been buying tier 1 debt on a selective basis. He thinks it makes sense to be cautious on shares in banks while being more bullish on their bonds. Although greater regulation of banks, which will force them to hold more capital reserves, could restrict their share price rises, the increased certainty is proving “very, very supportive” at the subordinated debt level, he says.

Subordinated debt is still compensating investors for the risks involved, with yields of 9-10 per cent. Senior debt, in contrast, yields around 5 per cent. “If you’re comfortable moving down the capital structure, there is significant extra yield on offer,” says Foden.