European bank capital securities, the term used to refer to subordinated debt instruments issued by financial institutions, have had a challenging 2018. Spreads on Additional Tier 1 (AT1) bonds are over 150 bps wider than in January, driven by uncertainty over Italy and Brexit negotiations, combined with heavy issuance, particularly in the U.S.-dollar-denominated market. Although this volatility could remain elevated in the short term, we think recent underperformance may be overdone and now could represent an attractive entry point.
Fundamentals remain strong
In recent years, the nonfinancial corporate sector in the U.S. has been releveraging. As an example, the share of investment grade issuers with a leverage ratio above four times net debt to EBITDA (earnings before interest, taxes, depreciation and amortization) rose from around 7% in 2010 to close to 20% in 2017 (Source: Morgan Stanley, Citi). This contrasts sharply with the regulatory-driven deleveraging trend in the banking sector, where today, banks have capital levels between two to eight times higher than before the financial crisis.
The improvement in fundamentals, at least from a creditor’s standpoint, is also evidenced by progress in cleaning up non-performing loans from bank balance sheets in Spain and even Italy (albeit to a lesser extent). Strong performance in the latest stress tests from the Federal Reserve and Bank of England also highlights banks’ increased resilience to severe macroeconomic shocks.
Volatility presents opportunity
Despite this backdrop, European bank capital has underperformed other higher-risk credit sectors this year, such as high yield. In the case of Yankee bonds (U.S.-dollar-denominated debt issued by European domiciled banks), underperformance was broad-based across the capital structure, driven by heavy supply and the resurgence of political risk in Europe. The result is that bank capital securities now offer yields over 7%, average duration of 3.7 years and an average credit rating of BB+; a combination we think offers an attractive entry point relative to other higher-risk credit markets (see chart).
In addition, bank capital securities display generally low sensitivity to rising interest rates. This is due to both their structure, which includes call options, and if the bond is not called, coupons that reset based on current swap rates, and the fact that historically, banks tend to see higher profitability when interest rates rise.
Avoid broad exposure and be selective
Although we continue to see value in capital securities, we think it’s important for investors to be selective and avoid generic exposure to the broad AT1 market. In particular:
- We are cautious on Italy due to political risk, preferring to take peripheral European exposure to banks in Spain, which benefit from a stronger economic backdrop.
- We remain constructive on U.K. banks, which are currently trading at higher spread levels due to Brexit, despite being some of the most capitalized issuers globally.
- We see value in U.S. banks, favoring the senior part of the capital structure where securities are highly liquid and look attractive compared to U.S. nonfinancials.
One benefit of recent volatility has been that the primary market has become more interesting, offering spreads up to 50 bps higher than equivalent offerings in the secondary market. This has presented opportunities to anchor select deals from top-rated issuers.
In this environment, investors do not need to chase deals in small or low-rated banks to try to meet return targets. Instead it’s possible to construct a diversified portfolio of capital securities with a yield over 7%, duration less than 4 years, and an average investment grade credit rating – a compelling combination of yield, duration and credit risk.
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