European banks are often the subject of opprobrium among the general public. Barely a week goes past without a slew of negative headlines or a new book raking over the muck of the financial crisis.

But credit investors are obliged to be dispassionate, and the fundamentals of a company play a far more important part in their asset allocation decisions than the swell of public opinion. If evidence is needed then look no further than the performance of bank CDS spreads this year. Shortly after the index roll in March, the Markit iTraxx Senior Financials was trading at 200bps. Now it is trading at 95bps, the first time it has dipped below 100bps since April 2010.

Central bank largesse and an improving economic picture boosted most risk assets over this period. Nonetheless, the spread tightening in banks may be surprising to some, given the weak earnings reported during 2013. Credit investors, however, are generally more concerned with the balance sheet, and the vast majority of institutions have bolstered their capital positions.

Regulations at a European level drove much of this improvement, and this is expected to continue next year with the ECB taking on the role as the single supervisor in the eurozone. The European Banking Authority has laid out the framework for the stress tests and asset quality reviews to be completed in 2014, and this probably will force some banks to raise more capital.

Institutions based in the periphery are particularly exposed, and Italian bank Monte dei Paschi is widely viewed as among the most vulnerable. So news this week that the bank's board had finally approved a €3bn rights issue - it was first announced two month ago - was welcome. The proposed capital hike, which still has to be approved by shareholders, will shore up Monte dei Paschi's balance sheet and enable it to avoid nationalisation.

Unsurprisingly, the Italian bank's senior CDS spreads rallied on the news. They are now trading at 335bps, a big improvement on the 730bps seen as recently as July. But it was the subordinated CDS that saw the most dramatic move. By Friday they were trading at 570bps, more than 100bp tighter than where they started the week.

Taxpayers are no longer the first line of defence when a bank gets into difficulties, and subordinated debt is now in the firing line, as was shown in the SNS Bank nationalisation earlier this year. The risk of subordinated bondholders being "bailed-in" under a nationalisation scenario is high, hence the relief from Monte dei Paschi's right issue.

Although the bail-in risk is present, it hasn't prevented subordinated CDS from rallying this year. The basis between the Markit iTraxx Subordinated Financials and its senior counterpart is now about 45bps, the lowest level for five-and-a-half years.

Two factors are probably driving this trend. First, bank capital positions have improved and the risk of nationalisation has diminished. Secondly, the ISDA CDS definitions are set to change next year, and there will be an additional credit event to account for bank bail-ins. However, this will only apply to new trades, so exiting protection will be less valuable. Therefore, fundamental and structural factors are compressing subordinated CDS spreads.

Quantitative easing, of course, has also made a large contribution to the rally in risk assets this year. The release of US non-farm payrolls next week, should give us a better idea of the Fed's timing for tapering its programme. A bumper report may bring forward expectations of tapering, which could shake the market out of its slumber and cause spreads to widen significantly

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