Many investors in Financial Contingent Capital Debt (commonly referred to as CoCos or AT1s) thought the asset class was dead after the collapse of Credit Suisse, but surprisingly 2023 turned out to be a profitable year for those who held their nerve.

The asset class went through a very turbulent crisis at the beginning of the year with the collapse of Silicon Valley Bank (SVB) and other US regional banks, culminating with the demise of Credit Suisse. Since then, the asset class has stabilised, investor confidence has returned, and the new vintage of AT1s issued in recent months is showing potential to generate high returns in coming years. This is due to a combination of wide credit spreads and an elevated rates environment resulting in very high coupons and higher probability of future calls.

Fixed income markets have struggled to adjust to rising interest rates and increased geopolitical uncertainty that has characterised the year to date. While the US Federal Reserve’s (Fed) incredibly hawkish interest rate policy has started to subside, geopolitical uncertainty looks set to continue. This has caused the spread in CoCos to widen as investors demanded better returns for the risk they were prepared to take. However, this is now beginning to reverse with government bond yields falling again.

Large risk premium

Within the fixed income universe, CoCos had been sold-off to a greater extent than other instruments, resulting in underperformance compared to banks’ Tier 2 and Senior bonds. This was largely due to the US regional banking crisis at the beginning of the year, sustained rates volatility and a lack of faith in the asset class after the controversial decision taken by the Swiss regulator in March. As a result, we believe there is still a large risk premium that remains between CoCos and high yield corporate bonds despite the strong fundamental position of the banking sector.

In fact, this spread differential is currently at the widest levels we have seen in recent years (see chart below). In other words, investors are offered a premium to take a smaller risk compared to generally lower rated high yield corporates. More specifically, one of the most important factors for investors to be aware of is that a lot of the downside risk has already been priced into CoCos, making future valuations quite attractive. Also importantly, we believe that the largest levels of volatility have already occurred, and the currently high coupons offered by AT1s offer a good degree of protection in case of further spread widening (high break-even point)

CoCos spreads v HY US “BB rated” corporates

(Source: Jupiter, 31/10/2023)

Currently, around 50% of CoCos are priced ‘to call’, which means the other 50% is pricing to a certain degree a risk of “extension” (i.e. to not be called at the first call date). This situation represents a compelling opportunity as banks have historically almost always called their AT1s at first call date (even during Covid) and certain AT1s would see their coupon increase in the event of a non-call. We believe the market is lacking differentiation amongst instruments and there are multiple opportunities available, offering an asymmetric risk profile with potential returns skewed to the upside.

Are banks fundamentally at risk in a high-rate environment?

Fundamentally, banks thrive in a high interest rate environment as they earn higher margins from collecting higher interest from borrowers while keeping rates on deposits generally low. Importantly, the deposit beta, which is the extent to which banks pass on the rise in interest rates to savers, is substantially lower for European banks compared to US counterparties. This is due to the fact that the Fed’s cycle of raising interest rates started earlier in the US compared to Europe, and also due to the easier to access to money-market funds in the US, which provide an alternative to bank deposits.

As such, despite approaching the peak, the margins for European banks are currently very attractive and act as a tailwind for the profitability of the sector. On the other hand, while asset quality is still very strong, we are at the late stage of rate cycle and funding has become quite expensive for the corporate sector. This dynamic will likely result in a deterioration of banks’ loan books during 2024. The increase in defaults and higher non-performing loans is a potential headwind, which could affect the balance sheets of any banks that have been less conservative in lending over the last few years.

Balancing out these two opposing forces, we believe that banks will manage to fare well through a potential slowdown especially if we consider that EU banks’ capitalisation levels are very strong on average, helped by improving credit fundamentals and robust profitability. Moreover, banks are already holding precautionary provisions under various macro-overlays, which provide further protection from a potential slowdown in economic activity.

Against this backdrop, we continue to like large and well-diversified financial institutions benefitting from stable and recurring sources of revenues and large capital buffers, as they can sustain large economic stresses. We are avoiding banks with substantial exposure to vulnerable sectors such as commercial real estate and to other cyclical sectors potentially more at risk during a slowdown. Especially after Credit Suisse, we continue to be very careful about the funding position of banks, avoiding those more exposed to short-term market funding and those relying on a less granular deposit base. At current valuations, despite spreads tightening from the post Credit Suisse high, we believe that CoCos still represent an attractive investment opportunity due to their high amount of carry, high break-even point of recent vintage and potential for further spread tightening towards or even inside generic high-yield corporate spreads.

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