Since mid-June, bonds issued by banks have enjoyed a strong rally in the run-up to the publication of the European banks' stress test results on Friday evening. It was thought that the tests would remove a lot of the uncertainty surrounding the banking system in Europe.

Unfortunately, I believe the test methodology itself was disappointing and simply not stressful enough. Moreover, the results in themselves were mixed to say the least. For a start the stress test of sovereign holdings was only carried out on banks' trading books rather than their "held to maturity" books.

This means that the majority of sovereign debt exposures of European banks were not captured by the tests, which showed a 20:80 distribution of holdings between trading books and banking books.

Furthermore, although increased from initial proposals, the assumed haircuts imposed on sovereign debt - and particularly Greek government bonds - were not, in my opinion, large enough. With Greek ten-year bonds yielding in excess of 10%, the markets today are telling us that a Greek default is not out of the question; so, in my view, the stress tests should not have ignored this sort of event.

The other issue is the pass rate of 6% which refers to various categories of capital as a percentage of a bank's total assets. This doesn't really tell us what we need to know in terms of the bank's ability to absorb losses. Nowadays when assessing a bank's creditworthiness, the focus is very much on core Tier 1 capital. Tier 1 capital does include assets such as equity and retained earnings, but it also includes hybrid debt instruments. A proper stress test I believe would show that large chunks of the European banking system is under capitalised.

On the positive side, the tests have revealed a lot of information which should enable the investment community to implement their own stress tests and decide for themselves which institutions could run into trouble based on certain assumptions.

The other plus is that these stress tests have confirmed our belief that bonds issued by the likes of Lloyds, Barclays and RBS are cheap. These banks went through onerous stress tests back in 2008 and raised, I believe, sufficient capital to ensure they could survive a severe downturn in the UK economy.

The results published on Friday night show these banks have tested Tier 1 ratios that well exceed the European average. In the case of Lloyds, the disclosures revealed no exposure to Greek, Irish, Portuguese and Spanish government bonds.

The Lloyds 15% 2019 "cocos" (contingent convertibles) that were issued last year to help the bank better manage its liabilities currently yield almost 11% to redemption and are a core holding for the Jupiter Strategic Bond Fund. I also hold positions in a number of bonds issued by Barclays and RBS.

Ariel Bezalel

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