The issues around inflation will be crucial in 2022. It appears that inflation will be around longer than markets initially expected, and the debate is focused on whether it will be a temporary phenomenon or a prolonged one. Also, the uncertainty arises with the definition of temporary. How long is “temporary”?
In the short term, inflation will most likely continue to have an impact on financial markets. Even if temporary means a one-year horizon or less it can still represent a risky environment for a fixed-income investor if you are not careful how you are positioned. The market’s perception of how long is “temporary” could also exacerbate the situation if such interpretation differs from the central banks’ view.
On the one hand, support measures for the economy are being removed, and inflation data is putting pressure on central banks to raise interest rates. On the other, central banks will have to be careful not to harm the recovery, which is still incomplete, especially in Europe.
Within our CoCos strategy, we believe it makes sense to keep a relatively low duration to mitigate the inflation risk (and the consequent interest rate volatility) while still benefitting from attractive yields offered by the asset class. By doing so we can reduce sensitivity to a movement in rates and at the same time we continue to focus on names and instruments selection as key driver of performance
It is worth noting that the current year has been positive for both financial credit and banking stocks from a fundamental but also a valuation perspective. Banks have proven to be quite resilient, having entered the pandemic with strong balance sheets with regard to capital and liquidity. Banks stocks have also benefited from the removal of the dividend ban, improved economic data and better interest rates outlook, which all support a more optimistic earnings trajectory. It is worth noting there were no defaults in the banking sector in Europe during the extraordinary times brought by the pandemic.
CoCos were created by regulators in the wake of an earlier crisis, the Global Financial Crisis, to help banks return to health without having to resort to taxpayer money in the form of bailouts. CoCo bonds turn into equity (or are written down) if a bank’s capital falls below a predetermined level.
One of the main advantages of CoCos is that they can offer attractive risk-adjusted yields. There is a “yield desert’’ for fixed income investors currently. The yield on CoCos exceeds that of investment grade and even high yield credit, especially in the US corporate sector. CoCo returns are also historically more attractive and less volatile in comparison to bank equity returns.
CoCos offer exposure to an improved European financial sector and a liquid market with many investment-grade issuers — including some of the region’s largest banks and insurers.
European banks have a strong capital position, well above the minimum regulatory requirements, and therefore are in a strong position to absorb losses from a potential asset quality deterioration.
2022 may be the first year of negative net supply for CoCos – with more redemptions than issuance – which is good from an investor point of view since it is supportive for valuations.
We carry out rigorous relative value, stress testing and fundamental analysis of CoCos and their issuers, and we believe this to be essential for investment in the asset class.
In summary, in 2022 we think CoCos will continue to offer yields that are attractive and well in excess of generic high-yield credit, with a much better risk profile.
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