Emma Wall: Hello and welcome to Morningstar. I'm Emma Wall and I'm joined today by Mike Scott, Manager of the Schroder Monthly High Income Fund.
Hi, Mike.
Michael Scott: Hi Emma.
Wall: So we're here today to give three stock picks or three bond picks I should say. What's the first bond today?
Scott: The first would be the lower Tier 2 bond issued by BAWAG Bank which is an Austrian regional bank. In our opinion, we think that the background or the trends within the financial sector are positive. We think that the regulator is forcing banks to raise an ever increasing amount of equity, to be held against the loans or within the balance sheet.
This is a positive thing from a creditor point of view. In particular with this bank it’s restructured quite heavily over the last three to five years. It's got out of the riskier end of lending. It's now pre dominantly involved in consumer and retail loans. And it is actually one of the few banks that is delivering double digit return on equity within the European financial space.
In our view the private equity owner, because it is still quite a small bank relative to the larger players within the space are likely to want to exit their investment and this will either come through an IPO or a sale. Usually in an IPO that requires further equity injection into the bank which again is positive from a creditors point of view. Secondly a sale to trade buyer would also increase the credit quality of the bank given it will be taken out by a much better capitalized or larger player.
Wall: You have described it as quite low risk there but I think a lot of people will see European bank and think that’s risky. So is the yield that they are offering reflective of the risk in that market?
Scott: Well, we think so. I mean they trade with a spread of 380 (basis points) over now these are Ba1 positive outlook bonds. We think that on a standalone basis these are investment-grade bonds. So investment grade bonds typically trade, say 200 to 250 over. So there is at least…
Wall: Good premium.
Scott: There is a decent premium already baked into the price and nonetheless we think on a standalone basis that the credit quality is investment grade. In the event that there is an IPO or a takeover of the bank than clearly it will be investment grade too. So we think that whilst the riskiness I guess of the bond is, or the credit is there. We think than that’s very much in the price.
Wall: And what's the second bond today.
Scott: The second bond today would be Iceland.
Wall: Frozen food retailer.
Scott: The frozen food retailer indeed. The high street or the food retail market has undergone quite substantial change over the last two to three years, in particular by the emergence of discount chains out a little. This has really been putting pressure on the top lines of high street food retailers.
Wall: To the detriment of Tesco and indeed Sainsbury…
Scott: Exactly but I think we are quite far through this process now, in terms of the price deflation. But nonetheless Iceland in itself actually we think holds a very important niche within the food retailing business. Its high street oriented, it’s frozen food oriented, where it’s the second largest player. We think that management is doing the right things with respect to investing its offer. It's slightly changing the proposition, as you say…
Wall: With advertising.
Scott: Through the advertising.
Wall: Do your whole Christmas frozen.
Scott: That’s exactly right, Pete Andre is leading that, we shall see whether or not that'll be successful. But nonetheless management is doing the right thing. They are investing the offer. It's one of the few food retailing companies where actually free cash are positive. Now the leverage through the bonds is 5.5 times. Recently a new investor came into the group, valuing the company at over 8 times to EBITDA.
Therefore there is a significant equity cushion within the structure beneath the bonds. Therefore we think that buying these bonds, the cash price of 88 to 90 a substantial discount to par we think that this is more, the risk is more than priced into these instruments. A fact we could see these bonds trading up at sort of 94 type level which would deliver a 12% for next year.
Wall: And what's the third and final bond.
Scott: The third and final bond would be Erste Tier 1. Now Tier 1 paper, these are old-style pre-Basel 3 capital, which will actually be redundant within the bank capital stock going forward as we are seeing more issuance of CoCo and alternative Tier 1 instruments. Now these bonds will be taken out at the first call in our opinion and first call date is next year. In the meantime, they are paying an 8.5% coupon or an 8.5% yield to that call.
Wall: Which is very attractive?
Scott: Which is very attractive relative to the likely volatility. In our opinion these will deliver probably the strongest returns of volatility characteristics of any bonds within the portfolio.
Wall: Mike, thank you very much.
Scott: Not at all.
Wall: This is Emma Wall from Morningstar. Thank you for watching.
