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Looking for value in high income credit

19 September 2018

Additional Tier 1 (AT1) debt has lost ground versus European High Yield (EHY) debt so far in 2018, with spread differentials currently exceeding 50 bps. The team at Atlanticomnium explain that this not only raises questions about the drivers behind the underperformance of bank AT1s, but also considerations about how risky they are compared to EHY debt. Overall, they find value in both AT1s and EHY, but believe AT1s offer more attractive yields with lower fundamental risk, especially in the context of deleveraging in the European banking sector and a continued trend of improving balance sheets.

After an impressive run in 2017, where Additional Tier 1 (AT1) debt returned more than 13%, 2018 has been more volatile and AT1s have underperformed European High Yield (EHY) debt year to date. This has been driven by the general weakness of risky assets, as well as AT1-specific factors. Heightened geopolitical risk (trade wars, populism, Brexit, emerging markets, etc), combined with a gradual shift towards monetary policy tightening by the European Central Bank, have pressured European capital markets. As a non-standard risk asset class (a perpetual structure with loss absorbing mechanisms) and with a less established investor base (under a decade of trading history), AT1s have proven to be sensitive to market sentiment.

Current valuations (Data as of 10/09/2018)

Source: Bloomberg, based on Bloomberg Barclays Contingent Capital EUR Total Return Index Value Unhedged and Bloomberg Barclays Pan-European High Yield (Euro) TR Index Value Unhedged as at 10 September 2018.

Past performance is not indicative of future performance. Indices cannot be purchased directly.

 

Chart 1: Performance of EUR Banks AT1s and EHY

Chart 1: Performance of EUR Banks AT1s and EHY  - image

Source: Bloomberg, based on Bloomberg Barclays Contingent Capital EUR Total Return Index Value Unhedged and Bloomberg Barclays Pan-European High Yield (Euro) TR Index Value Unhedged as at 13 September 2018.

Past performance is not indicative of future performance. Indices cannot be purchased directly.

 

Extension risk has also been a driver of AT1 returns. Extension risk refers to the fact that an AT1 is either called at par, after the requisite number of years, or the coupon can be reset for a further period. As spreads widen demand from those investors who buy on the expectation the bond will be called at a specific date lessens. In our view, spreads are more likely to narrow going forward, but concerns regarding extension risk have affected market prices so far this year.

Chart 2: Spreads: EUR Banks AT1s and EHY

Chart 2: Spreads: EUR Banks AT1s and EHY  - Image

Source: Bloomberg, based on Bloomberg Barclays Contingent Capital EUR Average OAS and Bloomberg Barclays Pan-European High Yield (Euro) Average OAS as at 13 September 2018.

Past performance is not indicative of future performance.

 

While price volatility has affected AT1s more than EHY, and remains a key risk for the asset class, we view the fundamental risk of AT1s to be lower than EHY. Bond investors generally break down risks into two major categories: credit risk (risk of default) and duration risk (risk linked to changes in interest rates). On top of this, we add liquidity risk.

We assess credit risk as being lower for AT1s compared to high yield as the largest AT1 issuers tend to be high quality global banking groups (for example HSBC, BNP, Rabobank), with strong credit metrics and diversified business models, whereas highly levered EHY issuers can have weaker credit metrics. Although AT1 are categorised as junior subordinated in the overall debt structure, we believe the probability of default remains significantly lower than that of EHY issuers and, therefore, the incremental risk stems from the structure of the instruments rather than the fundamentals of the issuers. Ratings are a good illustration of credit risk, with the typical AT1 issuer being rated in the “AA” or “A” category and, while AT1s are rated lower – “BBB” or high “BB” – on average, they still tend to bear higher ratings than EHY debt which is often “BB” or lower.

Although interest rate risk is broadly similar on average for AT1s and EHY (based on average duration), banks (the main issuers of AT1s) often benefit from higher interest rates as interest margins expand, while EHY issuers suffer from a higher interest burden on their debt. Finally, we see better liquidity in AT1s, which benefit from a larger average issue size than EHY (close to EUR 1 billion versus

Fundamentally, we believe we are in a sweet spot for the European banking sector. At the macroeconomic level, GDP growth and other indicators in the eurozone remain robust – driving demand for credit and consumers’ ability to repay their debt. On the back of a solid macro backdrop, asset quality continues to improve from both internal restructuring and asset sales; meanwhile, the clean-up of the banking sector remains at the top of the regulatory agenda and the acceleration of the disposal of non-performing loans is a positive overall.

The flipside of ongoing loose monetary policy is the persistently low interest rate environment, which has eroded banks’ interest margins and returns remain well below banks’ cost of capital (c 7% average return on equity versus an estimated c 10% cost of equity for European banks)1. However, banks have adapted to these low rates and have offset their contracting interest margins with a move towards fee-income oriented activities, alleviating some of the pressure.

Additionally, regulation remains a key positive for the sector, with a continued trend of strengthening banks’ capitalisation and balance sheets. European banks’ core equity tier 1 ratios (a measure of the highest quality of capital) has almost doubled since H1 2011, from 6.7% to 13.3% in H1 2017, as banks have raised capital in equity markets and retained profits2. Regulators have also imposed more stringent requirements on banks since the financial crisis – an ongoing theme as Basel IV requirements are set to come into effect in 2022, phased-in until 2027. We believe this should lead to a continued trend of capital accumulation, increasing the capital buffer for AT1 holders. Furthermore, the overhang from legacy litigation issues has decreased, as large ticket items have been resolved (RBS, Deutsche Bank, etc), or coming to a close (SocGen). Finally, technicals remain supportive for AT1s, as supply expectations (est. USD 25 billion pa3) should be limited to the refinancing of existing deals, as most large banks have filled their regulatory requirements.

Overall, in our view AT1s should be considered for investors seeking to capture high income and as a good diversifier in a portfolio with EHY but, based on current valuations, the risk profile of both asset classes and the continued positive trend in European banks’ fundamentals, we have a preference for AT1s.

1 Source: EBA risk dashboard 1Q18
2 Source: BIS data for capital ratios – H1 2011 to H1 2018
3 Atlanticomnium’s own estimates

 

Important legal information
 
Source: GAM unless otherwise stated.
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. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Past performance is no indicator for the current or future development.
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