Where do fixed income investors go from here?
With second quarter results from European banks well underway, it is worth taking a look at what is currently being priced into the Additional Tier 1 (AT1) market, how this compares to historical levels and whether this marries up to fundamentals.
The first thing we see is a hefty amount of extension risk currently being priced into the AT1 market. Many bonds are trading to perpetuity, with the index as a whole trading at a cash price of 90 and a yield to perpetuity of 7.20%. The UK’s Nationwide Building Society, for example – an extremely conservative mortgage lender with one of the world’s largest capital buffers – has an AT1 bond trading at 91, with a yield of 8.00% in sterling to its 2027 call and a yield of 7.50% to perpetuity. Should there be this much extension risk priced in? Firstly, the call is five years away and the reset rate on the bond if Nationwide chose not to call is considerably higher than the index trades on average. Secondly, as we have seen many times before, banks are very keen to maintain their relationship with bondholders (most recently evidenced by Credit Suisse paying 120bp more to refinance an existing bond), which would suffer great damage in the event of a non-call. In addition, even if you were to price the bond to perpetuity we would argue that at 7.50% this is still a very attractive opportunity for an investment grade rated instrument. Overlooking diversification for just a moment, the vast majority of investment objectives could be met with this bond alone.
Looking at today’s levels in a historical context highlights the current opportunity we see in AT1s. Analysts at Citi recently noted that having widened by 350bp so far this year, AT1 spreads are now wider than they were at the end of 2018 (when trade tensions and central bank tightening were spooking investors) and at similar levels to those seen during a mini crisis for the market in early 2016, when concern over Deutsche Bank’s ability to pay its AT1 coupons sparked a wider sell-off. Indeed, the only time the sector has looked more attractive at the index level was for a very brief period in 2020 at the peak of the COVID-19 crisis. Citi also pointed out that a lack of upcoming supply in the market, as well as fund flows beginning to turn around, could create a strong technical tailwind for AT1s in the second half of the year.
Turning to fundamentals, we have been very vocal about the elevated capital buffers banks have grown and maintained after being transformed in the aftermath of the global financial crisis. The aforementioned COVID crisis was a stern test that banks passed with flying colours, with the sector actually managing to increase its capital levels through the worst recession in history. The metric that has impressed us more recently though is the relationship between banks’ cost of risk and net interest margins. Cost of risk is the amount of provisions (held against losses) a bank takes divided by its loan book size, while net interest margin (NIM) is in essence the profit margin on a bank’s book. Cost of risk is currently at historically low levels, while NIM is robust and improving due to central bank rate hikes. If we look at the results published by UK lender Lloyds on Wednesday, NIM came in at 2.77% year-to-date with cost of risk at just 0.17%. While we will most likely see cost of risk nudge up slightly over the coming period, the large gap between the two measures points to strong organic capital generation at Lloyds, and we see a similar dynamic occurring across the banking sector. Markets appear to either be looking through this fact or ignoring it completely, and as a result AT1s are pricing in a much worse scenario that we don’t think will materialise.
In our view, earnings are demonstrating that banks are very well placed currently and have huge buffers to weather any upcoming volatility. Meanwhile, the market is pricing in an unwarranted amount of extension risk with attractive opportunities even in the worst case outcomes. These are rare levels, only seen in past times of extreme stress, and history suggests they are a good entry point.