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Lower rates for longer

14 August 2019

Dovish guidance from the European Central Bank (ECB) has erased the prospect of higher rates in the foreseeable future and led to significant repricing of bank equities on consensus earnings downgrades. Romain Miginiac, Credit Analyst at Atlanticomnium, explains why the lower for longer interest rate scenario that is currently priced in by investors is supportive of his bullish view on subordinated financial credit.

Backdrop – where are we on rates?

Since the beginning of the year, global interest rates have significantly declined, fuelled by dovish central bank guidance, a lack of meaningful pick up in eurozone growth and inflation and rising economic uncertainty (trade wars, Brexit). As the European Central Bank’s (ECB) rhetoric has grown increasingly dovish, hinting at potential further rate cuts or asset purchase programmes, European interest rates have plummeted to record lows – 5-year German government bond yields are around -0.6%, while total negative yielding debt has ballooned above USD 12 trillion (see Chart 1) to reach a new all-time high. Expectation of future interest rates reflects a ’lower for longer’ scenario, with a 90%+ implied probability of rate cuts before the end of the year, according to Bloomberg. Long-dated Euribor futures have also fallen below 0%.

Chart 1: Negatively yielding debt balloons on renewed dovish ECB guidance

Source: Atlanticomnium, Bloomberg as at 15 July 2019. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.

Implications for issuers – earnings story, not credit story

Such expectations of lower rates for longer have led to downgrades in bank consensus earnings and in turn the repricing of bank equity prices lower (Chart 2). Lower rates impact banks’ profitability from reduced net interest income and compressed net interest margins – in particular from the excess liquidity held at the central bank and in high quality sovereign bonds. While we continue to see low rates as a headwind for earnings, and we believe they will inevitably weigh on profitability for the sector, we believe the positive credit story underpinning banks’ credit remains intact. The story is supported by stricter regulation which has led to significant capital accumulation and de-risking since the financial crisis, making the financial system stronger and more resilient.

Chart 2: Eurozone bank equities are highly geared to interest rates

Source: Atlanticomnium, Bloomberg as at 12 July 2019. Left axis refers to the Euro STOXX Banks Index. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.

For bondholders, the impact of a mild erosion of banks’ return on equity (RoE) is largely irrelevant as the overall fundamentals of the sector continue to improve. Looking at Chart 3, European banks’ common equity tier 1 (CET1) ratios1 have more than doubled since the financial crisis – from 6.1% in 2007 to 14.8% in 2018, increasing their capacity to absorb losses in a severely adverse scenario. This reflects the accumulation of core equity via profit retention, equity raising and the reduction of risk-weighted assets (de-risking) to comply with ever-increasing capital requirements. We believe the implementation of Basel IV should lead to further capital accumulation – with an estimated circa EUR 40 billion2 incremental total capital needed to cover new requirements. The long phase-in period, from 2022 to 2027, will allow capital to gradually build up organically through profit retention.

On top of strengthening capital positions, European banks have also significantly cleaned up their balance sheets – another strong credit positive. The average non-performing loan (NPL) ratio for EU banks has fallen from 6.5% at the end of 2014 to 3.1% at the end of the first quarter 2019. This has been partly driven by a structural reduction in risk taking by European banks, as regulation has disincentivised excessive risk taking by imposing large capital charges on riskier assets. The ECB’s dovish monetary policy has also contributed to improvements in asset quality. As monetary policy has led to a recovery in the eurozone economy, with declining unemployment and stabilised GDP growth, individual and corporate balance sheets have improved. This has been further helped by record low borrowing costs and interest burden, boosting borrowers’ ability to service debt and reducing defaults. Going forward, low growth and low inflation dynamics are supportive for European banks, as accommodative monetary policy should ensure a stable economic backdrop.

Chart 3: Banks’ capital ratios have more than doubled since the financial crisis

Source: Atlanticomnium, company documents as at 31 December 2018. For illustrative purposes only.

Profitability remains underwhelming for European banks and is one of the key challenges highlighted by the European Banking Authority (EBA) for the sector. With an average RoE of around 7% in the past four quarters3 to Q1 19, this is well below non-European peers and banks’ own cost of equity, estimated to be around 8-10% by the EBA. Although low rates have contributed to downward pressure on banks’ returns due to lower net interest income and especially negative interest rates charged on the EUR 1.8 trillion of excess liquidity parked at the ECB, other structural reasons have contributed to weak profitability. The European banking system is highly fragmented, with a large number of small banks, dense branch networks and slow adoption of technology driving fierce competition, declining margins and high cost bases in the sector. Last, but not least, increased capital requirements from stricter regulation eroding banks’ RoE is actually a positive for bondholders.

Nevertheless, both banks and the ECB have tools available to smooth the hit on earnings. Banks have been living with the low interest rate environment for several years and consequently have adapted their business models by favouring fee-driven segments, such as asset management, thereby reducing their sensitivity to interest rates. Reducing costs by improving operational efficiency should alleviate some pressure and offset some of the decline in interest income. Moreover, the ECB has discretion to mitigate the impact of further rate cuts for banks. TLTRO III, for example, should allow a new round of ultra-cheap funding for banks, reducing overall funding costs. Inclusion of bank debt in future asset purchase programmes could help reduce funding costs further (it was previously excluded from the ECB’s corporate bond purchase programme – CSPP). Finally, deposit tiering, where part of banks’ reserves at the central bank would be exempt from negative rates, has also been discussed, which would relieve some pressure for European banks. Ultimately, as credit investors we focus on earnings stability to support capital generation rather than profitability itself.

In a nutshell, we view regulation as the key driver of bank fundamentals – with further capital accumulation on the horizon and structurally de-risked business models. Accommodative monetary policy remains supportive for asset quality.

Implications for banks’ subordinated debt – the bull case

Our starting point to build our bullish view on financials’ subordinated debt is straightforward: continued improvements in fundamentals of the sector and highly attractive valuations. Lower interest rates for longer is the cherry on top, as the hunt for yield in EUR-denominated fixed income is a supportive environment for further spread tightening. With an average yield of only 0.2% on close to USD 12 trillion of high quality EUR-denominated fixed income securities and a large portion of sovereign debt with negative yields, there are very few hiding places for credit investors. In euro investment grade bonds, corporate bonds with a maturity of 10 years or more is one of the only segments offering yields above 1% – with significant interest rate risk. The trade off between duration risk and income yield has become highly unfavourable – at a 1.2% yield with around 12 years of duration, it takes some 10 years of income to make up for a 1% increase in interest rates (illustrative) in long-dated credit. With a renewed monetary stimulus and the potential for another round of asset purchasing programmes (ECB buying sovereign and corporate bonds), spreads and yields are likely to compress, leading to a further hunt for yield as investors are starved of returns.

Chart 4: Limited options for investors seeking yields above 1%

Source: Atlanticomnium, Bloomberg as at 16 July 2019. For illustrative purposes only.

We believe financials’ subordinated debt is well positioned to benefit from the ongoing hunt for yield in EUR-denominated fixed income, offering high quality income. EUR additional tier 1s (AT1s), for example, are among the highest yielding instruments in EUR credit with close to 4% yields, more than five times above that of BBB corporate debt. Interest rate risk is significantly lower for AT1 contingent convertible bonds (CoCos), as the asset class’s duration is around 3.5 years and historic sensitivity to interest rates close to zero (source: Atlanticomnium, Bloomberg), as reflected in Chart 5 below. Even at similar ratings, EUR AT1 CoCos offer yields close to twice those of BB high yield bonds, despite much stronger fundamentals in our view. With limited interest rate risk and very cheap valuations for rock solid credit quality, subordinated financials debt should benefit from yield-starved investors looking for high quality income.

Overall, the lower for longer interest rate scenario that is currently priced in by investors is supportive of our bullish view on financials subordinated credit. While European banks will continue to face headwinds due to low rates, regulation that continues to strengthen banks’ credit profiles is the key catalyst for the sector, in our view. Further capital accumulation is anticipated, and low interest rates and a stable macro context are supportive for banks’ asset quality. With renewed dovish monetary policy, yields have reached historic lows and there are limited portions of the EUR fixed income market offering yields in excess of 1%. This scenario is constructive for financials’ credit, in our opinion, as it offers highly attractive yields in a negative rate environment and screens cheap compared to the interest rate risk and underlying credit risk-facing investors.

Chart 5: AT1 CoCos show limited correlation with interest rates

Source: Atlanticomnium, Bloomberg as at 12 July 2019. Left axis refers to the Bloomberg Barclays Euro Contingent Capital Bond Total Return Index. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.

1 Aggregate for European banks with assets > EUR500 billion – using FX rates as of 16 July 2019, Source: Atlanticomnium
2 Source : EBA
3 EBA risk dashboard

Important legal information
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 for the current or future development.