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Active Thinking: Banking Profits - why the prospects for European credit remain positive

Investment grade credit spreads have been in a sweet spot of late, despite volatility in underlying government bond markets. Gregoire Mivelaz of Atlanticomnium shares five reasons why he is enthused over the outlook for actively managed credit portfolios.

05 November 2024

Having faced two-year-long headwinds of rising government bond yields from late 2021, European credit markets have been thriving in more favourable conditions ever since, boosted by solid corporate earnings, especially from financials, and confidence that the European Central Bank (ECB) had finally got to grips with inflation.

While geopolitics will inevitably produce some short-term uncertainties during the months ahead – potentially creating mispricing opportunities for active managers to exploit – in our view, there are five main factors that should remain supportive for credit markets.

More rate cuts ahead

History tells us that environments of central bank rate cuts are beneficial for credit, potentially driving capital gains, in addition to the attractive yields investors can harvest. While some recent data from the US jobs market has raised questions over the likely pace of Federal Reserve interest rate cuts, we expect the ECB to be at the forefront of decisive Europe-wide rate cuts over the next year or so, a factor that should boost total returns for credit investors.

Bank fundamentals are the strongest in recent history

While banks have capitalised on higher interest rates since 2020 with much-improved net interest margins and profitability, their earnings and balance sheets are now in very robust shape, and well-positioned for the ongoing central bank easing cycle that has been widely anticipated by investors. While any return to ZIRP – the Zero Interest Rate Policy – that was implemented by the ECB up until mid-2022 could potentially be harmful to bank earnings, we think this scenario is extremely unlikely, with the ECB deposit rate forecast to fall from the present 3.25% to around 2.50% late next year.

Chart 1: Financials - one of the most resilient sectors

Fundamentals are at their strongest in recent history… good for bondholders

 
Past performance is not an indicator of future performance and current or future trends.
Source: Atlanticomnium and Bloomberg as at March 2024. CET1 = common equity Tier 1. The views are those of the manager and are subject to change.
The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.

Yields on subordinated bank debt still look attractive

Given the strong fundamentals across the banking sector, subordinated debt yields of circa 6.5% look very appealing to us. In our view, spreads remain very wide and have scope to tighten, while rates are still high and have potential to normalise. What is more, market technicals are extremely strong, as indicated by demand on the primary market. Spreads on senior bank debt may have already reverted to their historical base levels, but spreads on subordinated bonds remain some way above their lows of early 2018 and 2020, with real potential to tighten from present levels.

Chart 2: Reasons to own subordinated debt

… Strong fundamentals combined with attractive yield

 
Past performance is not an indicator of future performance and current or future trends.
Source: Atlanticomnium and Bloomberg, 30 Sep 2024. The views are those of the manager and are subject to change.
The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.

The market’s healthy appetite for CoCos

Contingent Convertible Bonds (CoCos) – hybrid securities issued by banks, designed to meet their regulatory capital requirements and provide a buffer against potential losses – have seen major supply this year, with banks issuing around USD 30 billion. But this was covered more than six-fold, as investors bid for around USD 190 billion of these CoCos. This excess demand indicates strong interest and broad confidence in the asset class, with investors keen to accept the higher yields on offer relative to subordinated debt in return for the risks associated with their loss-absorbing characteristic.

Capturing pricing anomalies with active portfolio management

As active managers, rather than slavishly following an index, we can adjust our positioning within the capital structure as we seek out the most attractive opportunities, based on our assessment of market conditions and the associated risk factors. For example, having favoured significant allocations to Additional Tier 1 (AT1) CoCos last year, we have since been gradually reducing our exposure to AT1 CoCos in favour of Tier 2s and senior unsecured bonds.

The active management advantage in fixed income investment allows for better control of credit risk and price volatility, leveraging market inefficiencies to enhance returns, especially during periods of market volatility. By focusing on subordinated debt, which offers high levels of yield from investment-grade issuers, active managers capture attractive compounded returns while managing the heightened price volatility inherent in such assets, particularly AT1 CoCos. Although AT1 CoCos are typically called at the first call date, periods of market stress can lead to temporary repricing, creating opportunities for active managers to capitalise on mispriced extension risk. By using a quantitative approach to assess extension risk, active managers can optimise allocations, reducing downside volatility while positioning for both high income and potential price gains, ultimately achieving superior risk-adjusted returns.

Looking at AT1 CoCos that are callable perpetual bonds, over the past 10 years, one third of price volatility has been driven by spread movements, while two thirds of price volatility has actually been driven by extension risk (which also explains why AT1 CoCos tend to be 2-3x more volatile than Tier 2s).

Chart 3: Active management key in subordinated debt market

Market volatility creates opportunities

 
Past performance is not an indicator of future performance and current or future trends.
Source: Atlanticomnium and Bloomberg, January 2024. The views are those of the manager and are subject to change.
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 not a reliable indicator of future results. There are no guarantees that the objectives of the investment strategy will be realised/achieved.

While 95% of AT1 CoCos have always been called at first call date, we have identified five periods over the past 10 years where investors have fully re-priced these bonds to maturity and this was independent from banks’ fundamentals (ie trade wars, fears of slowdown in China, Covid, invasion of Ukraine, etc).

Chart 4: Extension risk is a great buy/sell indicator

One of the best indicators

 
Past and current trends should not be relied upon as an indicator of future trends.
Source: Atlanticomnium and Bloomberg, March 2024. The views are those of the manager and are subject to change.
The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.

The implications for investors are clear: extension risk is mispriced most of the time (ie should only be priced at 5% as 95% of AT1 CoCos have always been called at first call date, independent of market conditions). This mispricing can be used by active managers with the benefit of reducing the price volatility to the downside while fully benefiting from the high carry, as well as potential price appreciation as these bonds gradually reprice to next call date (hence superior risk-adjusted returns).

Since extension risk can be quantified and measured, it also means that the active allocation across the capital structure is entirely quantitative, measurable and repeatable.

Chart 5: Actively managed strategy

Finding the best opportunities within the capital structure

 
Source: Atlanticomnium and Bloomberg as at 30 Sep 2024. The views are those of the manager and are subject to change.
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 not a reliable indicator of future results. There are no guarantees that the objectives of the investment strategy will be realised/achieved.

As the below table demonstrates, we believe that a continuation of the pattern of robust quarterly earnings from European financials, the false perception that subordinated debt – including from investment-grade issuers – must be riskier than high yield bonds, and the excessive pricing of extension risk, can be ongoing drivers of returns from European credit over the short and medium term. We further believe investors can benefit from the attractive levels of coupon income that can be captured from credit markets, with subordinated debt, predominately from investment grade issuers, looking particularly good value to us at present.

Chart 6: Looking ahead

We see multiple mispricing opportunities to exploit

 
Past performance is not an indicator of future performance and current or future trends.
Source: Atlanticomnium, August 2024.
The views are those of the manager and are subject to change. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.

Gregoire Mivelaz co-manages the Credit Opportunities and Climate Bond strategies at GAM Investments .

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 or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index.

The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the markets 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.

Gregoire Mivelaz

Fund Manager, Atlanticomnium SA
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