DBS - Government link importance

We maintain our Outperform recommendation on the DBS Bank (‘DBS’) US$725m Tier 1 perp note, lower our recommendation on the 19c14 to Market Perform from Outperform, and maintain our Market Performs on the other three US$ notes. DBS’s US$ perps yield 17% to call and we forecast a one year total return of 23%. We believe much of the value in these notes reflects an overstatement of the likelihood that the bank will not call the notes at the step-up coupon date in March 2011 and the problems at major international banks that are dragging bank capital prices lower globally. We view DBS as one of the strongest bank credits in Asia ex-Japan. This strength stems from its ownership link to Singapore’s investment arm Temasek, its ability to raise additional capital, and its current financial position. We believe the key risks are 1) a sharp hike in NPLs in the coming 18 months (we forecast NPLs to peak at 6.7% next year), and 2) ongoing weakness in global bank capital prices.

Government link and systemic importance: Temasek (Aaa/AAA) effectively owns 28% of DBS and is an investment arm of the Singapore government (AAA/Aaa). We believe Temasek has both the ability and the inclination to support DBS’s future capital issues. Should DBS not be able to get finance from the capital markets and/or Temasek, we believe the government would provide capital support to the bank. DBS is the largest of three domestic banks in Singapore and hence is systemically important. Moreover, Singapore is a regional financial center and the perceived financial health of its banks is important to attract international investors.

Sound financials: DBS’s current capitalization seems sound, with an estimated tier one of 12% and total CAR of 16% post the SGD4bn rights issue. As at end-FY08, the NPL ratio was 1.5% and provisions fully covered these for losses. The bank also maintains a very strong liquidity position. The loan deposit ratio was a low 77% at end-FY2008. We believe the bank also has a sound reputation among depositors in its two key markets of Singapore and Hong Kong. This stability in deposit funding is augmented by deposit guarantees from both governments.

Call risk mis-priced: On our estimates, the market is pricing the chance of DBS not calling the notes at 30%. We see this risk as less than 10%. We believe much of this is driven by international investors’ fear of bank capital due to large losses at many large banks. There also is a large disconnect with comparable local currency notes that trade at far lower credit spreads. Management has said it values the trust investors place in DBS when investing in these securities. While the bank has not explicitly stated it will call the notes at the first step-up date, we believe that only if it faces severe financial stress at the time of the call would it not exercise its call option. Given its liquidity strength and relatively strong ability to raise capital, we see a non-call as unlikely. We also see the chance of a missed coupon in the interim as remote.

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