Ratings uplift a boost for European financials

Moody’s announced two notable rating upgrades on Thursday and Friday as Ireland’s two largest banks, AIB and Bank of Ireland, had their issuer ratings upgraded from A1 to Aa3 and their Additional Tier 1 (AT1) instruments upgraded from Ba1 to Baa3. Also on Friday, S&P upgraded Dutch insurer ASR from A to A+ and its Restricted Tier 1 (RT1) instruments from BB+ to BBB-.

For the banks, Moody’s cited strong asset quality, capitalisation levels and core profitability as factors behind the upgrades, in addition to large volumes of stable deposits and high levels of liquidity.

In all three cases, the upgrades elevated the issuers’ subordinated debt to investment grade (IG). Secondary trading on Friday highlighted how impactful that move can be, with the affected deals outperforming the rest of the junior subordinated financials space by around 0.5-1 points.

While the upgrades are valuable for the issuers, they also have implications for fixed income investors.

First, they reflect the ongoing quality improvement we see in European financials. Both banks and insurers have posted very solid fundamental results this year, with many reporting figures ahead of their own expectations despite the interest rate cuts delivered by the European Central Bank. This earnings strength has helped bank equities to materially outperform, with the Euro Stoxx Banks index up 58% year-to-date versus 10% for the broader market Euro Stoxx 50 (the latter includes some financial names). The sector’s latest price-to-book ratio stands at 1.20x, which implies European banks overall are achieving more than their cost of capital.

Second, the proportion of the subordinated financials universe that is IG rated continues to grind higher. More specifically, 66% of outstanding AT1s now have at least one IG rating (it was 57% in August 2020 according to Crédit Agricole data), as do 100% of all benchmark-size RT1s. If we consider composite ratings – taking an average of the three main rating agencies – then 42% of AT1s and 96% of RT1s are composite IG rated. Financials are also outperforming the broader market in this respect. Exhibit 1 shows the difference between the upgrade-downgrade ratio in financials and all corporates (which includes financials) across the three major ratings agencies; the differential dipped in the Covid period as analysts anticipated weaker loan performance and slower earnings due to low interest rates, but it has been recovering strongly in recent years.

The main point here is that a large share of junior subordinated debt of European banks and insurers is already rated at IG level, and this share continues to increase. The issuers’ ratings are also mechanically several notches higher than their subordinated debt, which highlights the remote probably of default the ratings agencies see from these institutions.

Finally, we do believe the higher ratings of the financials universe may help to dampen volatility in future sell-offs. This might sound obvious as the credit quality of issuers is better, but there is a technical impact as well as many institutional investors have mandates that restrict them to investing in IG rated bonds. Because the pool of money targeting IG bonds is significantly larger than the pool of money targeting non-investment grade (high yield) bonds, there is naturally a larger bid to “buy the dip” in the former. In our view, this could help better align price action in subordinated financial paper with its credit risk.

Overall, we remain constructive on European financials and are pleased to see the sector’s performance being reflected not only through share prices but also through gradually improving subordinated debt ratings, which tend to lead to higher valuations. Further upgrades could lead to spread tightening and some erosion of the spread premium vis-à-vis non-financial credit, but as bondholders we do get the benefit of fundamental improvements and a wider investor base that could bring about lower volatility in the asset class.