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Outlook 2024: Romain Miginiac (Subordinated Debt)

Subordinated debt – A clear dislocation between fundamentals and valuations

December 2023

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After a choppy 2023, marked by chaos in the US banking sector and the acquisition of Credit Suisse by UBS, global bond markets have suffered a big drop, as investors adjust to the reality of prolonged high interest rates. Bondholders can benefit from high levels of carry - 10.9% yield to call on European banks’ Additional Tier 1 (AT1) Contingent Convertibles (CoCos) and convexity given potential for spread tightening and as bonds get called at par. Despite short-term turmoil, we believe the current market dislocation is indeed presenting an attractive entry point in subordinated debt markets, especially for high yielding assets with solid fundamentals.

Strong fundamentals

Fundamentals have never been as supportive for bondholders – big banks had strong Q3 earnings, signified by ‘ugly’, ‘bad’ and ‘good’ features. The ‘ugly’ feature is that earnings may have already peaked at decade high double-digit return on equity (ROE). The ‘bad’ is capital stagnation around all-time highs – more than EUR 500 billion excess capital. The ‘good’ is the stubbornly benign loan loss provisions and non-performing loans (NPLs) – the credit quality of the sector is undoubtedly strong.

Attractive valuations

The strength of the European banking sector is not adequately reflected in the current valuations, in our view. With around 530 bps of spread between option-adjusted spread (OAS) and treasury (circa 11% yield to call), it is hard to find a lens through which AT1s do not screen well. AT1s currently offer circa 100 bps (1%) spread pick-up to high yield and to US bank preferred stock – around the highest differential seen over the past decade. On top of high income, this is a first leg of potential price upside, as there is high potential for spread tightening.

Convexity and call advantages

Investors can potentially benefit from significant convexity, which is how bond prices and yields change in a non-linear way when interest rates fluctuate, as market fears of extension risk lower prices further. Around two-thirds of AT1s are still priced to perpetuity, reflecting fears around issuers’ ability to refinance bonds. Non-calls remained the exception in 2023, with over 90% of AT1s redeemed at their first call date (circa USD 111 billion out of USD 118 billion). We believe bond redemption will remain a supportive feature of the market in 2024, with at least 80% of AT1s expected to be called even at our most conservative expectation. In our view, many upcoming calls in 2024 are already safe because some AT1s had been pre-financed and could be replaced at a similar or lower cost. On top of this, adding the willingness from most European banks to pay some incremental cost, and banks’ ability to call without refinancing by using excess capital, leaves limited call uncertainty.

The case for financial subordinated debt remains intact in our view, with a clear dislocation between fundamentals and valuations. The ‘status quo’ catalyst – ongoing strong earnings from the sector in upcoming quarters and bonds called at par – supports a normalisation of spreads. While investors in AT1s tend to benefit from high carry, potential for spread tightening and bonds re-pricing to call leaves the door open for price appreciation and solid overall total returns looking at the next 12 to 24 months.

Source: Bloomberg, Atlanti. All data as of 31/10/2023.

Important disclosures and information
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein 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 contained herein. 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 or an invitation to invest in any GAM product or strategy. 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 nor represent any recommendations by the portfolio managers nor a guarantee that objectives will be realized.

This material contains forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.

Romain Miginiac

Fund Manager & Head of Research at Atlanticomnium SA
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