Spanish banks have had a tough time in recent years but their performance in the CDS market suggests the outlook may be improving.

Spreads in the three biggest lenders - Santander, BBVA and Caixa - have tightened by about 100bps since the beginning of the year, and have outpaced the Markit iTraxx Senior Financials by some margin. The positive trend is even more noticeable over the last four months.

Much of this is due to the Spanish economy starting to recover from the doldrums. The country emerged from recession this week, with third-quarter GDP rising by 0.1%. Spain's sovereign CDS hit 185bps on Wednesday, their tightest level since August 2010, and the September Markit PMI showed that Spanish services companies were at their most optimistic for nearly three and a half years.

A pick-up in the embattled Spanish economy is clearly welcome, though the 26% of the working population that are unemployed may be wondering when they are going to see the benefits.

And it would be premature to say that the economy is out of the woods yet. Third-quarter results from the three banks this week demonstrated that the corporate sector is still feeling the pain. Non-performing loans were up and net interest income was down. Spreads in all three names widened, though when the recent rally is taken into account the movements were negligible.

Earnings and revenues were also lacklustre, with flagging growth in Latin America not helping matters. But credit investors are more focused on the balance sheet, and in particular capital adequacy. BBVA expects to have a fully loaded core tier one ratio of 9.5% by year-end, compared to 8% at Santander. This meets the 8% requirement laid out in the ECB's comprehensive assessment document published earlier this week.

The ECB is preparing an in-depth asset quality review and stress tests of Europe's banks ahead of assuming its role as the single supervisor in November 2014. Spanish banks, along with others in the periphery, will surely seek to bolster their capital positions over the next 12 months.

Download full article