24 July 2020
Atlanticomnium’s Romain Miginiac suggests AT1 contingent convertible bonds (CoCos) are well positioned to outperform in the coming years underpinned by resilient credit quality in an uncertain environment and remote default risk in the context of rising defaults.
Chart 1: Global HY and AT1 CoCos Total Returns – Year-to-date returns close to flat, supported by a swift recovery and high income buffers
AT1 CoCos and global HY have performed broadly in-line YTD, with total returns still slightly negative (-3.1 and -2.6% respectively). Despite significant drawdowns due to Covid-19 related uncertainty, both asset classes have recovered around 80% of the drawdown. Prices have significantly recovered as a result of unprecedented global coordinated fiscal and monetary easing, and positive economic momentum driven by gradual easing of lockdown measures in most developed economies.
While performance is broadly in-line on a YTD basis, AT1 CoCos have significantly outperformed global HY over the past five years (total returns of 44% versus 29% respectively), see Chart 1. While we see value for high income investors in both asset classes, we continue to see European bank AT1 CoCos as extremely well positioned to continue outperforming over the next five years. Our view is driven by resilient fundamentals in the face of Covid-19 uncertainty, supportive technicals and attractive valuations.
European bank fundamentals resilient to macro deterioration and rising defaults
Looking at fundamentals of both sectors, before diving into Covid-19 related effects, it is important to remember how HY and subordinated debt investors achieve high levels of income. HY investors are paid higher income by taking elevated credit risk, investing in companies with higher levels of leverage and higher probability of defaults, reflected in a low credit rating (BB+ and lower). Subordinated bondholders are able to capture higher income by being more junior in issuers’ capital structures, and hence potentially facing higher losses in the event of defaults. This is mitigated by issuers’ higher credit quality, and therefore lower probability of defaults. As an example, the AT1 CoCo Index has an average rating of BB / BB+ at the bond level, but the average issuer rating is BBB+ / A-. This compares to BB- / B+ for the global corporate HY index. Subordinated bondholders benefit from the strong credit quality of issuers, which provides significant protection.
In the current context of significant uncertainty driven by Covid-19, issuers’ resilience will remain the key for preservation of capital. Global economies are expected to contract severely in 2020 and only to recover by 2021 / 2022. Lower growth induced by strict lockdowns, where company revenues are impaired is likely to lead to higher leverage (mechanical increase of debt to EBITDA metrics as profitability declines), and higher borrowings to safeguard liquidity. Ultimately, as credit risk increases from higher leverage and lower cash flow generation, default rates are poised to increase, which has already started to materialise. Over the past five years, global HY default rates have averaged a low 2.8%, which has been supportive for the HY asset class, see Chart 2. As defaults rise from a very low base, potentially more than doubling and up to high single digit according to some estimates, this will inevitably create headwinds for future HY returns over the next 18-24 months.
Chart 2: Global HY defaults rate poised to rise after low levels
The banking sector continues to be highly resilient, despite Covid-19 related effects. As we have seen with Q1 2020 results (see our recent article titled ‘Q1 bank results: Covid-19 has not derailed the credit story’), higher loan loss provisions will be absorbed by earnings, while regulatory easing has led to an increase in capital buffers to protect bondholders. We expect Q2 results to confirm this trend – an earnings and a not a balance sheet story. Regulation continues to be the key positive driver of European bank subordinated debt. While in the short term regulatory easing provides additional headroom to absorb potential losses and allows the banking system to continue supporting the real economy, the longer-term trend of capital accumulation is unchanged. Basel IV is set to be implemented in 2023 and phased-in until 2028 (timeline has been pushed back by a year due to Covid-19), which will force banks to further strengthen their capital base. As mentioned in our previous piece, there is currently circa EUR 750 billion of loss absorbing capacity (EUR 550 billion of excess capital plus EUR 200 billion of earnings capacity) in the European banking system before AT1 coupons are at risk. Overall, fundamentals continue to be supportive for AT1s in our view, with resilience in the short term and visibility over further strengthening over the medium to long term.
Supply outlook is supportive for H2 2020, fallen angels the biggest risk
Issuance of European bank AT1 CoCos has been relatively heavy YTD, due to changes in regulations brought forward that allow banks to fill a higher proportion of their capital requirements using subordinated debt (AT1 CoCos and Tier 2), see Chart 3. This is expected to drive EUR 10-15 billion of net AT1 supply (compared to a market size of circa EUR 200 billion) in the market, with otherwise close to zero net supply as the large issuers have filled their 1.5% minimum allowance and focus is now on refinancing. As new supply is likely to be modest over the second half, with significant front-loading of issuance ahead of Q2 2020 results, supply and demand dynamics should remain a positive tailwind for the asset class.
Chart 3: AT1 CoCo issuance has surged in H1 2020
In the HY space, supply has also been elevated as issuers took advantage of very tight spreads in early 2020 and normalised market conditions in late Q2 and the early days of July. While it is expected that issuance will slow down in the second half of the year, in line with global credit markets, fallen angels pose a bigger threat for the asset class. Low rates and tight credit spreads have led to a growing “BBB” credit market, now standing at USD 6 trillion, or close to three times the size of the global HY market, see Chart 4. A decade ago the market was “just” USD 2 trillion or around one-and-a-half times the size of global HY market. In the current context of downgrades and deterioration of credit profiles of issuers, a significant amount of fallen angels (ie investment grade issuers being downgraded to HY) could cause significant growth of the HY market, a negative technical.
Chart 4: BBB corporate debt has surged to reach three times the global HY debt market size
Valuations screen cheap, AT1 holders benefit from convexity of a re-pricing to call
Currently, spreads on both European bank AT1 CoCos and global HY screen as attractive around 550 bps and 600 bps, respectively, see Chart 5. Spreads on global HY bonds are now wider than AT1 CoCos although these have been at similar levels on average in the past five years. A simplistic explanation could be that HY bondholders are paid an extra premium for potential higher default risk. In reality, spreads on AT1 CoCos are understated due to overdone fears around extension risk and the significant re-pricing to perpetuity that we have seen in the asset class. Extension risk is the risk that a bond does not get called at the first call date, which is especially of relevance if the bond does not have a fixed maturity. Depending on whether investors are pricing the bond to next call date or maturity, this can have a material impact on the price of the bond.
Chart 5: Spreads on AT1 CoCos and global HY screen attractive
Extension risk is the key driver, where during the large selloff seen during March virtually the whole market re-priced to perpetuity (ie pricing that bonds would be left outstanding forever). Despite the strong price recovery, there is still a considerable portion of the market (currently around 75%) that remains priced to non-call. Therefore, spreads to call are significantly higher than spreads to maturity – currently spreads to call are slightly below 700 bps or close to 100 bps of spread pick-up to HY, see Chart 6. Although we might see a few idiosyncratic “non-calls”, overall, the risk of bonds being left outstanding forever is very limited. Very large reset spreads (ie spreads at which the coupon would reset if not called) protect bondholders against the risk of non-call, currently on average around 500 bps. This is significantly above average spreads over the past five years, closer to 400 bps. In “normal” market conditions, it would be economic for issuers to refinance these instruments rather than skip the call date for most instruments, hence extension risk is limited in our view. Out of 19 AT1 CoCos up for call in 2020, only two were not called until now, while 12 have been called and three already pre-financed, therefore only 10% not called compared to 75% of the market pricing for a non-call, clearly reflecting the overshooting of extension risk this year. For AT1 CoCo holders, as the market re-prices to call, there is significant upside on top of potential spread tightening.
Chart 6: Spreads on AT1 CoCo understate true upside potential
Furthermore, another consideration is compensation for credit risk. The 600 bps average spread on HY masks large disparities between the higher and lower quality spectrum. For example the average rating on “BB” rated bonds is 430 bps, well below the average and the spread of circa 650 bps on “B” and 1160 bps on “CCC” rated bonds, see Chart 7. As the AT1 CoCo index is skewed towards BBB and BB (both making 90% of the index), whereas B and lower make up around 40% of the global HY index, AT1 holders are paid higher spreads for an equivalent bond rating, and significantly higher issuer rating. We view compensation for subordination risk of high quality issuers where the probability of default is remote as overly generous.
Chart 7: AT1 CoCo holders paid generously for subordination risk
Overall, while valuations are attractive on both AT1 CoCos and global HY, we view AT1s as very well positioned to outperform in the coming years underpinned by resilient credit quality in an uncertain environment and remote default risk in a context of rising defaults. Moreover, there is a potential opportunity to capture attractive spreads of around 550bps, around 400bps of pick-up compared to global investment grade corporate bonds. Extension risk is a positive tailwind and there is scope to benefit from re-pricing to call. Compared to the last five years where AT1s returned 7-8% annualised (43% total return), spreads are currently wider than five years ago, and a large portion of the market is priced to non-call. We see significant upside potential.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers.