Capturing European banks' improving fundamentals
Strong capital ratios despite challenging share prices
As the spread of Covid-19 has caused an unprecedented shutdown of global economic activity, investors are faced with heightened uncertainty and as a result yields across risk assets have moved materially higher in 2020.
During this period, central banks have expanded their toolkits including unprecedented fiscal stimulus packages with the aim of supporting the economy as companies and individuals face challenging times.
With government bond yields generally falling and yields in risk assets rising, the amount of negative yielding debt outstanding has fallen to $8.9trn.
Among the current backdrop, investors may consider searching for income in sectors that offer an attractive yield and demonstrate improving fundamentals.
Central bank policy and the low interest rates experienced in recent years has translated into weaker profitability for European banks, creating volatility for European bank equities.
Interestingly, when you look at the iBoxx Contingent Convertible Liquid Developed Europe AT1 index, you see a different picture. While the index has faced a large market correction along with other risk assets year to date to 25 March 2020, this index has exhibited significantly lower volatility than the STOXX Europe 600 banks index over multiple periods.
From a fundamental perspective, European banks have reported strong capital ratios, even if share prices look challenging.
If we look at capital adequacy ratios since the 2008 Global Financial Crisis, we see a generally improved picture of health for European banks. This has driven the size of Additional Tier 1 contingent convertible bond (AT1 CoCos) market to nearly $223bn as of 31 December 2019.
AT1 CoCos are generally issued by European banks and are hybrid bonds designed to help banks meet capital requirements imposed on them by the Basel III regulatory requirements which were put in place after the Global Financial Crisis.
While not all banks are equally strong, if we look at the S&P ratings of European banks that issue AT1 CoCos, we observe that they have benefitted from more rating upgrades than downgrades since 2017.
These European banks have, on average, an S&P rating of A-, noticeably higher than the US high-yield market which has an average issuer rating of BB. For a sector that has relatively strong fundamentals, investors may find attractive levels of income by going down a bank's capital structure.
While European bank subordinated bonds typically offer a higher yield than senior debt, they also come with greater risk due to contingencies within their structure.
AT1s have an embedded trigger which, if pulled, can be converted to equity or written-down.
The triggers are generally associated with a Common Equity Tier 1 (CET1) ratio of 7% for high-trigger contingent convertible bonds (CoCos) and 5.125% for low-trigger CoCos.
If we take a snapshot of the maximum trigger levels of AT1s issued by large European banks and their respective CET1 ratios, we currently note large capital buffers from the maximum trigger levels of their AT1's within their balance sheet.
AT1s were one of the top-performing asset classes within fixed income in 2019 and continue to provide an attractive yield relative to other risk assets.
Amid the market volatility, many asset classes have been faced with a strong correction from the high price levels seen in January 2020. While AT1 CoCo spreads and yields on 20 March were significantly higher than at the start of 2020, this was broadly in line with the big moves seen in other risk assets this year.
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AT1 CoCos have benefitted from lower drawdowns in performance than European bank equities, outperforming them by 14.6% year to date to 20 March this year.
We believe there will be a bifurcation within credit markets in 2020 and investors will show strong demand for sectors that offer yield meanwhile benefit from strong fundamentals.
With the average issuer S&P credit rating for this sector at A-, AT1 CoCos could be an area of particular interest in comparison to other yield segments such as high yield.
As the asset class exhibits a low correlation to European and UK government bonds, AT1 CoCo's can contribute to overall portfolio diversification and be an income play.
The improving fundamentals of banks and attractive yield offered by AT1 CoCo's could present an interesting investment case for European banks if investors are comfortable with the inherent risks embedded within them.
Lidia Treiber is director, research at WisdomTree
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