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.

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.

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