So far this year, investment grade credit spreads have widened across-the-board. Unsurprisingly, the worst performing sectors in the global IG universe have been energy and metals & mining where index spreads are 108bps wider*. Spreads on the financials component of the Barclays Global Aggregate Corporate Index are 38bps wider this year – in line with the broader market. However, month-to-date, financials – and especially subordinated bank bonds – have underperformed the broader market. European bank CoCos, which are not included in standard bond market indices, have been especially hard hit in recent weeks with the average price of bonds in the BofAML Contingent Capital Index marked 11 points lower (at 91.29 from 102.34) year-to-date.
So what do we believe is causing this volatility among financials? Rather than one specific cause, we see a number of factors that have caused the market to react in such a manner, including:
Financial conditions and market sentiment have deteriorated in recent weeks, but we maintain our positive view on European banks’ credit fundamentals and improved resilience.
From a credit perspective, we remain comfortable with the balance sheets of most banks. Since the last financial crisis, tougher regulation has resulted in substantial deleveraging and balance sheet strengthening in the European banking sector, and banks today are significantly better capitalized. At the same time, regulation has driven banks to improve liquidity – their reliance on short-term wholesale funding is materially lower than eight years ago and banks keep large pools of liquid assets. Over the same period, European banks’ loans/deposits ratios and asset quality have improved meaningfully and while the stock of non-performing loans remains sizeable for some European banks, progress continues, supported by low interest rates.
While the recovery continues, there are challenges for the sector.
Ultra-low interest rates put pressure on net interest margins, loan growth remains low and rising macro growth concerns may impact activity. However, from a credit perspective, we expect the offset from asset quality improvements to be a net benefit. We continue to be cautious regarding banks with outsize exposure to emerging markets and/or commodity sectors, and some regulatory uncertainty remains.
As a result, issuer and security selection remain key – especially in the AT1 universe.
Given their complexity and high beta/equity-like nature, AT1 investments require an in-depth understanding of the issuer’s credit fundamentals, the structural features of the instruments and the regulatory environment. Our credit analysis focuses on a thorough analysis of fundamentals (including stress testing) of issuer-specific regulatory requirements, as well as the structural risks of such deeply subordinated securities (coupon suspension and extension risk, for example).
We favour higher quality, retail-focused and well capitalised banks in countries with greater regulatory clarity, such as the UK, Switzerland and Scandinavia. We have avoided banks with meaningful exposure to EM and energy/commodities sectors. Additionally, we are focused more on domestically-oriented retail banks, with lower risk profiles and more stable earnings, rather than issuers with large investment banks, which we believe may see more earnings volatility and ongoing litigation risk.
*Year-to-date to 10 February 2016, Barclays Global Aggregate Corporate Index