The return of vicious counterparty risk - and what you can do about it

The enduring sovereign debt crisis in peripheral Europe and concerns over the strength of European banks is bringing disquiet about counterparty risk back to the fore, according to RMG Wealth Management’s Stewart Richardson.

The group’s chief investment officer said continuing uncertainty surrounding Greece and the potential for an imminent default, coupled with Italy’s credit default swap levels hitting a record high on Monday, are stoking concerns about the state of European banks.

He said: ‘With what is happening in Europe, we would be careful over who we structure anything with, which is why we are not doing too much on the structured product front at the moment. For example, we don’t want a longer-term strategy with structured notes.

‘We have concerns over European banks in particular. Their balance sheets are in a much worse condition than they would have us believe, especially with the sovereign debt crisis.’

Richardson said the firm errs away from longer-term structures, as it does not want to be locked in with five or six year tenors and therefore exposed to the counterparty, even if there is a good degree of secondary market liquidity. He added: ‘There’s so much going on with the macro environment, so we prefer shorter-term exposure.’

For example, the firm’s portfolios have previously invested in reverse convertible products. ‘We have used these as a way to implement individual stock or sector ideas, but volatility has dropped lower recently and so we are not using them at the moment,’ said Richardson.

Reverse convertibles with short tenors can be used to gain a return on the movement in a stock price. A three-month product would mean if the stock closes below the strike price at maturity, the investor would receive shares in the company plus a coupon, gained from the put option. If the stock closes above the strike price, the investor receives back the initial capital plus the coupon.

However, with counterparty risk and bearish sentiment on Europe, Richardson said the firm only has one structured product in clients’ portfolios at present.

‘No legwork has really been done to solve the problems with European banks, and many are holding a high amount of European sovereign debt. Even if certain large banks don’t have massive exposure, it is the interconnectedness of the European market that worries us,’ he said.

‘We have been bearish on European equities and the whole Europe project for the last 12 to 15 months. We didn’t think Greece would get out of this unscathed. The European policymakers have been trying to paper over the cracks, but the outcome has to stem from Europe’s epicentre.