The last quarter of 2018 was disastrous for most risk assets. Everything from equities to commodities experienced a correction. Senior bank capital was no exception and we believe the risk/return ratio deserves to be considered at the present levels. While the case is true for both EUR and USD, we think EUR notes should be favoured as the IG USD investment space offers plenty of opportunities.
The shape of the interest rate curve in the US is, amongst others, a source of concern for investors, as it is close to becoming inverted – an inverted yield curve is usually seen as a reliable predictor of recession. Short term rates being higher than longer term rates is problematic for banks. One way for a bank to generate profit is to borrow and lend money. Banks usually lend money and therefore receive interest on long term loans whilst paying interest on shorter term deposits. A narrowing term spread therefore negatively impacts their profitability.
In Europe, the bleaker economic outlook, as well as the probability of interest rates remaining at very low levels for an extended period of time, does not play well for bank profitability either and does not make banks the most obvious choice for a bond portfolio.
Bank senior debt credit spreads have, like most other credit spreads, been on a widening trend over the last quarter. The move was further exacerbated at the beginning of the year with Senior bank debt suffering a repricing in the first few days of January, a move we believe was due to the large number of issuers filling their 2019 funding plans all at the same time. The widening occurred despite an upbeat start to the year, with investors being more inclined to adopt a “risk-on” attitude.
We have been long advocates of a defensive approach, encouraging investors to select quality issuers for their fixed income portfolios.
We have also acknowledged the difficulty in implementing a defensive strategy in EUR portfolios as usually the yield of such a strategy barely covers costs.
Following the recent price correction, we think select Senior bank debt offers an interesting risk / return profile at current levels.
Some may argue the current situation is not an appropriate time to on-board bank issuers, as we may be nearing the end of the cycle and during the last crisis, bank debt was particularly hit. While we agree that developed economies are showing the early signs of a slowdown, and that the US yield curve inverting would be detrimental for banks, when these reasons are considered, it would encourage us to look for non-cyclical issuers.
However, since the last crisis, regulators have forced banks to substantially strengthen capitalisation and to adopt a loss absorption mechanism, in the form of contingent convertibles, which are designed to bear the brunt of losses arising from a devaluation of a bank’s asset base.
Senior capital, usually being low beta, should suffer much less than during the previous recession, as banks are now better equipped to face liquidity and solvency constraints.
Earlier this year, the European Banking Authority published its Risk dashboard which summarises the main risks and vulnerabilities in the EU banking sector. While the institution acknowledge profitability remains weak, they highlighted the fact that bank capital ratios remain high and that the quality of EU bank loan portfolios has improved.
While the Senior investment grade space in general seems attractive to us, we recommend selecting the bigger, better capitalized banks in the high investment grade spectrum. From a duration point of view, durations of 4-6 years onwards should be considered, as this is the point where EUR Swap rates become positive.
As a specialist fixed income services company, bridport & co publishes regular comment on bond market activity. Get more information at www.bridport.ch
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