Last year was a challenging one for investors in European financials, with bond prices coming under severe pressure. We, however, draw comfort from the fact that when the market has endured negative years in the past it has typically gone on to see a price recovery in the following year. Moreover the companies issuing these bonds generally seem in good health from a credit standpoint; therefore we tend to resist the temptation to react to short-term volatility and do not change anything in terms of how we do things and how our portfolios look.
So far in 2019, history has proven to be an accurate interpreter of market behaviour and positive performance has been generated in the early part of this year. Additionally, the requirement that the regulator has imposed on banks regarding their capital requirements has been a definite boost for the financial sector.
Since the implementation of capital adequacy requirements in 2012, the financial strength of European banks has improved immeasurably. Despite the challenging market conditions of the last year these institutions are now passing the European Central Bank (ECB) and Bank of England (BoE) stress tests, which was not the case even as recently as 2016 and is a welcome development. The result of such ongoing regulatory pressure is that the banks have a much bigger equity buffer, which is a positive for us as bond investors. We are now starting to consider the implications of Basel IV, which commences in 2022, but in our view nothing significant will change from the Basel III capital requirements.
Good examples of European financial institutions with strong fundamentals are HSBC, Lloyds Banking Group, RBS, Barclays and Rabobank; each of these has built up their Common Equity Tier 1 (CET1) buffer. We have few doubts about the ability of any of these to pay either their coupon or the principal back on their subordinated debt. We anticipate that the UK banks in particular will continue to increase their equity buffer and significantly de-risk, even with the continued uncertainty around Brexit. For a bond holder that represents an extraordinary investment case, in our view; we have witnessed the likes of RBS increase its CET1 from 8.6% to 16.7% between 2013 and 2018. This continuation of banks strengthening their balance sheets is in part why we remain so constructive on the sector.
Chart 1: European financials rebuilding their capital (CET1)
Source: Bloomberg, as at February 2019.
However despite this, the perception of investors towards the financial sector remains weak (which has been amplified by many negative headlines in the press). In our view, the reason is not because of the fundamentals; the equity price of European banks has been under pressure because of profitability rather than solvency, liquidity or capital adequacy and this has resulted in an enormous disparity between returns from the equities and subordinated debt of European banks.
Meanwhile the Purchasing Managers’ Index (PMI) has been falling over the last year as it was pricing in too much growth, but we believe the underlying story remains quite strong for Europe and, again, supports our positive outlook. Unemployment is falling – last year it came down from 8.5% to 7.9% – which is helping to drive momentum and is part of the reason why domestic consumption in Europe is so strong.
与此同时，采购经理人指数（PMI）在过去一年中一直在下降，因为它定价过多增长，但我们认为欧洲的基本面仍然非常强劲，并且再次支持我们的积极前景。失业率正在下降 - 去年它从8.5％下降到7.9％ - 这有助于推动势头，也是欧洲国内消费如此强劲的部分原因。
Extension risk (when a perpetual bond which has no fixed maturity does not get called and the bond needs to be re-priced) has been another concern for investors (please read our recent article for more detail) as happened in February when Santander did not call its contingent convertible bond (CoCo) as expected. Extension risk was less of a discussion point in the past because every time a bank or an insurance company issued a bond to institutional clients there was a gentleman’s agreement that the bond would always get called. However under the Basel III regulations, specific to CoCos, even if the bond is issued in a traditional way the bond does not need to be called unless there is a clear economic rationale for doing so and has therefore led to an increase in extension risk. This will continue to be a consideration when investing in CoCos, although we believe the worries are overdone and priced in, and may actually represent an opportunity. Our view is that CoCos will increasingly be priced to next call date rather than priced to perpetuity.
Chart 2: As spreads widened, investors priced AT1 CoCos to maturity
Source: Bloomberg, as at February 2019
To us, the investment case for European financials remains compelling. The credit quality of companies in which we invest is generally strong and income is for the most part steady and predictable. On both an absolute and a relative basis, valuations look extremely attractive at this point in time. The combination of income and expected price recovery, stemming from both spread tightening and legacy securities being called at a profit, gives us cause for optimism going forward. Ongoing regulatory changes in the form of the Capital Requirement Regulation 2 (CRR2) and Basel IV are also likely to create further opportunities in our view.