Three credit trades for a tough 2012

Europe's existential crisis and the threat of a rating downgrade that hangs over the much of the region has sparked Royal Bank of Scotland (RBS) analysts to reduce their forecast for equity returns in 2012, cutting their prediction from 11% to 3%.

But in an environment offering little payback for taking on risk through shares, the investment bank is instead turning to a series of critical credit trades.

1.Rising defaults and struggles to de-lever in Europe

Declining growth and tighter lending will force this theme to prominence in 2012.  RBS recommends going short on subordinated debt, but long on senior-rated paper.

'European banks have to de-lever their balance sheets by at least 20% of assets over the coming three years to five years (€5.1trillion), in our view. Combined with high funding costs and slow growth, we think this will push banks to sell assets and impose more burden-sharing on sub-bondholders, as raising equity or deposits becomes increasingly difficult,' RBS' Alberto Gallo, a senior credit strategist, explained.

Best trade idea:  Buy iTraxx Sub Financials and sell iTraxx Senior protection.

2. High yield default rates will double

These rates have already jumped from 1% to 2.6% over the two months to the beginning of December and RBS' Gallo anticipates a further rise next year, with defaults potentially climbing as high as 5.6%.

'European high yield firms rely on loans and will face a steep redemption schedule in 2012, while at the same time loan demand from non-bank buyers (CLOs) will likely decline,' Gallo said.

Trade this theme by snapping up iTraxx Xover and selling CDX HY protection.

3. Short Aussie and Korean bank risk

Unlike the domestic lenders in Europe, Asian banks typically have far more manageable exposure to Europe.  The exception to this is Korea, and outside Asia, Australia.  Both have maintained strong and enduring ties to debt-laden parts of the continent and this means that by contrast to their peers some Australian and Korean banks are highly levered.

In turn this implies these financial institutions could have substantial re-financing needs.