Credit quality: issuers generally performed according to expectations.
Income: income levels were in line with expectations and historical averages, which was supportive for those seeking income generation.
Low sensitivity to rates: despite normalisation / volatility on rates, negative performance was driven by spread widening rather than rates.
Well-capitalised banks: recent stress tests conducted on European and UK banks confirmed the sector is resilient and banks are well capitalised.
Performance:despite their strong fundamentals, the price of securities in the subordinated debt universe came under pressure, irrespective of the high and predictable income that they have generated. We have always said that the only factor cannot be controlled over a short-term investment horizon is the price of securities held. However, a focus on high quality companies should enable the price of such bonds to recover once the market stabilises.
Benefits of diversification: diversification did not work as well as it should have in 2018 as the subordinated debt of insurance companies underperformed the supposedly weaker credits of Additional Tier 1 (AT1) contingent convertible bonds (CoCos) of banks. Legacy securities of both banks and insurance companies also came under pressure, especially those which should mitigate interest rate risk. Even corporate hybrids and senior unsecured debt from corporates performed in line with, or in some cases worse than, subordinated debt of financials.
In 2019 we expect to see attractive income levels and anticipate that prices will recover. We believe current valuations of financial credits are attractive on both an absolute and relative basis. The level of spread that can be captured does not, in our view, reflect the strong fundamentals of the bonds. As the market normalises, we do expect a sharp price recovery over the next six to 12 months, which should be complementary for income generation.
The universe of subordinated financial debt has a market cap of USD 787 billion (Source: Bloomberg Barclays Indices as at 18 December 2018) of which USD 610 billion is in banking and USD 177 billion in insurance. We believe this highlights the scope of the opportunity available to investors in this space.
While we hear many differing forecasts and confusing macro cross currents, for our part we will continue to focus on the simplicity of an investment area which boasts an array of highly selective and diversified strong individual credits, many of whom are national champions paying higher yields than in 2018, and the benefits of collecting coupon income.
With credit quality remaining strong and the effect in bonds – which is not there for equities – of pull to par, we believe prices should recover once the dust settles from 2018 price volatility. Fundamentally, a secular theme of further balance sheet strengthening as well as deleveraging from the financial sector is supportive for subordinated debt holders. We believe income will be a strong driver of performance going forward; there should also be a benefit, at some stage, from capital gains.
A more detailed look at some of the points mentioned follows below.
Chart 1 shows spread moves in the subordinated debts of banks / insurers on the following three indices:
AT1s CoCos – Barclays Bloomberg European Banks CoCo Index (Global) OAS
Banks Lower Tier 2 – Barclays Bloomberg Capital Securities Banking LT2 Index (Global) OAS
For Insurance Lower Tier 2 – Barclays Bloomberg Capital Securities Insurance LT2 Index (Global) OAS
Chart 1: Banks & Insurance Subordinated Debt Spreads
Past performance is not an indicator of future performance and current or future trends. For illustrative purposes only.
Spread widening has occurred even as, from the beginning of 2016 to Q2 2018, the average Common Equity Tier 1 (CET1) ratio increased by 140 bps to 14.3%, which made the financial institutions safer in our view and hence we anticipate further spread tightening.
Furthermore, we also feel the coupon risk on AT1 CoCos has significantly decreased as the European Central Bank (ECB) split its Pillar 2 requirements into a hard requirement (which counts for maximum distributable amount (MDA) purposes) and guidance – hence increasing the buffer to regulatory requirements.
In the current environment, we believe legacy bank capital securities could be attractive investments, the rationale being that these securities will be phased out as banks’ regulatory capital and we have seen a number of securities being redeemed in recent years, which can be done via calls, tenders or exchanges. We expect the bulk of capital securities to be withdrawn in some way through to the end of 2021 (the end of the grandfathering period) which could result in a positive outcome for investors.
Overall we expect banks to continue cleaning up their capital structure; we believe the process will accelerate as we move towards the end of 2021.
The call or non-call of AT1 CoCos is largely an economic decision for a borrower. During 2018, spreads widened significantly, with the EUR CoCo index more than 200 bps wider. The financials subordinated debt market has been hit by both the negative price movements (from spread widening) and a subsequent repricing to perpetuity from increased extension risk (the risk of bonds not being called at the next call date by the issuer, meaning the bond price is likely to decrease as investors require a higher yield or spread to compensate for the potentially longer holding period).
As the bonds reprice from call to maturity, the impact of a move in spreads wider to perpetuity has had a greater impact on prices compared to moves in spread to call.
It is worth noting that despite the move in 2018, we assess bonds on a yield to worst basis (lower of yield to call (YTC) and yield to maturity (YTM)) rather than an assumption of whether the bonds will be called or not. We still find compelling valuations in the bonds, on both a YTC and YTM basis.