By Simon Miller

European fixed-income investors are worried that increased use of secured funding by banks could lead to potential structural subordination according to a survey from Fitch Ratings.

The Q2 2011 Senior Fixed Income Investor Survey found that 87% of those surveyed were moderately or very concerned over bank senior unsecured creditors will become increasingly structurally subordinated as banks increase the use of secured funding tools such as covered bonds.

Out of the majority concerned, 16% were very concerned because “higher asset encumbrance increased the loss given default for unsecured creditors”.

Fitch believes that the growing use of covered-bond funding by banks is set to continue in the near term, fuelled by investors risk aversion as well as regulatory incentives.

In addition, Fitch said the current environment of stable-to-deleveraging bank balance sheets, “growing covered-bond volumes mean that this class of debt is an increasingly important source of funding for come banks”.

The survey noted: “With the increasing potential for resolution regimes to replace whole-bank bailouts, matters of structural and legal subordination also gain significance.”

The survey also found that investors feared losses on sovereign debt from developed markets. While a majority of participants saw limited future credit loss, 55% of respondent s believed that SM sovereigns had yet to peak in terms of loss-taking. Indeed, sovereign debt problems remained the greatest risk factor to the European Credit market with 89% believing the risk to be high.

While, sovereign debt remained the prime concern, investors are also uneasy over the end of easy money.

The risk factor from the end of central bank credit market easing and quantative easing grew by 16% from Q1 this year, to 65% in Q2.

On the investment class front, although European investors remained relatively optimistic on the booming high-yield asset class, the strength of this sentiment is fading.

"High-yield corporates remained in top spot as most favoured choice by investors, although by a reduced margin compared to the previous quarter," said Monica Insoll, managing director in Fitch's Credit Market Research group.

The share of survey respondents expecting improvements in fundamental credit conditions for high yield also reduced to 40% from 53% in Q1. Compared to the other six asset classes monitored in the survey, optimism about fundamental credit improvement is now stronger for banks as well as for corporates - both investment grade and emerging markets. High yield was at the top of this list in the previous survey.

"Issuance of European high yield has surpassed €20bn thus far in 2011, and with a crowded pipeline it remains on course to surpass 2010's record of €34bn by the summer," said Edward Eyerman, managing director of Fitch's EMEA Leveraged Finance team.

"However, such rapid growth in demand continues to draw supply from more challenged sectors and includes riskier structures, including more 'CCC' rated issuance. Consequently, the outlook for default rates to increase from current lows may shift towards the second half of 2011 and into 2012," he added.

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