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STATE OF AFFAIRS
Looking under the boot of bank balance sheets in search of risk factors leaves you with an almost insurmountable task. Indeed, the vast amount of assets and the complexity of the funding or passive stack confronts an investor in bank credit with a multidimensional problem to solve. If you throw into the mix the regulator’s minimum requirements and thresholds across liquidity, funding, percentage in loss-absorbing capital, simple leverage and risk-weighting terms you should expect a decent risk premium for such a number of uncertain outcomes. Yet, the panic over Q1, Q2 2020 across credit markets was extremely short-lived. Governments and bank regulators stepped up and allowed for a broad series of debt guarantees, moratoria across household mortgages or small and medium enterprise bank debt facilities and relaxations on standing, existing bank regulation. In return, banks had to pause dividend distributions. A nice trade-off assessing Q1 bank results (across both sides of the Atlantic). Several of these programs are still up and running today. Fact is that the bank credit risk premium has fully normalised back to pre-COVID levels. First, we briefly reflect on the credit risk premium for European bank credit across the capital stack. Second, we will raise a few questions as we pause on the impact of uncertainty in relation to the leverage metric as well as the overall business model risk.
From low to high we observe a cash bond spread of 5bp for covered bonds, 68bp for EUR Preferred Senior, 98bp for EUR Bail-in Senior, 136bp for EUR Tier 2 and 364bp for EUR AT1. For reference, at the height of the crisis in March 2020, the EUR Bail-in Senior spread peaked around 325bp versus 425bp for EUR Tier 2. A market shock typically carries a factor between 3 to 4 for bail-in senior or Tier 2 paper depending on remaining maturity and bank rating quality. The yield on EUR AT1 deeply subordinated debt surged towards a broad 6%-8% range. Effectively, the fear factor of potential coupon passes, temporary or permanent write downs or even equity conversion risk rose, as trigger levels on pillar 1 requirements were considered. A cratering call probability pushed the yield to worst (YtW) and yield to maturity (YtM) towards each other. Today, yield to worst attaches an extremely high call probability again, leaving yields in between 3.5% and 4.00%. On a yield to maturity basis, we pencil in a 5% to 6% range. With the call certainty re-established, the difference between YtW and YtM falls again just below 2.00%. Covered and preferred senior bonds sit comfortably high in the capital structure and enjoy flight to quality flows the moment systemic banking risk rears its ugly head. Essentially, one might ponder that the least attractive risk/reward profile falls on the capital instruments in the middle of the capital stack represented by Bail-in Senior and dated subordinated T2 credit. With a mere 40bp spread difference across the two sectors, investors reach yields between 0.50% and 1.50% within the 7 to 10-year maturity bracket.
Above yields and spreads from covered to preferred bank credit, from bail-in senior to T2 ending up with AT1 deeply subordinated paper, have to remunerate the investor for the risks embedded on the asset side of a bank’s balance sheet. Typically, a bank will issue a minimum of 2% of risk-weighted assets (RWA) in Bank T2 debt. The regulator also stipulated a minimum pocket of 1.5% of RWA in issuance of AT1 bonds. Essentially, depending on amount of CET1 (core equity T1) that ranges between 12% and 18% across European banks we achieve total capital considerations between 19% and 24%. Adding senior bail-in bank debt and large banks reach total loss absorbing capital levels between 25% and 30%. We do not comment on the split between what’s legally binding (Tier1), what the regulator can require based on the conduct of its yearly Supervisory Review and Evaluation Process (SREP) known under the name of Pillar 2 Requirements and the combined buffer requirements that belong to the overall CET1 capital needs. The point I want to make is that any abrupt or slow deterioration of bank assets (household mortgages, SME and large corporate credit facilities, bank book of government bond investments and other structured or derivates-related exposures…) should get reflected in the risk premium attached across the capital stack. Such shocks occurred in 2008-2009 as well as during the European debt crisis of 2011-2012 and last year’s pandemic cataclysm. Whereas, during the GFC of 2008, the banking sector was fully bailed out by governments – at a certain cost – the shocks of 2011-2012 and 2020 where different. During the EU debt crisis, the respective quality or non-quality stamp of government debt holdings on bank’s balance sheets was the main differentiator of bank credit risk premiums. With the advent of European safe assets (initially through the Next Generation EU EUR 750 billion funding program) the national government bond credit risk should continue to compress. The regulatory zeal of the past 12 years, more than tripling bank capitalisation, led to the successful passing of a major stress test in 2020. Fact is that default event risk has collapsed as the all-important level of high-quality Tier 1 capital (CET1), including above-mentioned combined buffer requirements, has strengthened systemically important banks (globally or domestically). All these efforts prevented last year’s market cardiac arrest to spill-over into permanent damage on bank credit spreads. The regulator scored good points. But let’s not fool ourselves. We ask again, are spreads between 90bp to 150bp for senior bail-in and T2 high enough?
So, what about current asset quality? As economies start to reopen, government guarantees and payment holidays (moratoria) will start to fade and disappear. The non-performing loans (non-payment exceeding 90 days) sit under the label of Stage 3 loans. A look across Stage 3 releases comfort. However, whenever we take Stage 2 loans – defined as not yet credit-impaired but showing a fragile profile or increasing credit risk – in consideration, our level of confidence is shrinking. Adding Stage 2 and Stage 3 loans versus bank capital depicts a less robust picture. Also, at times, weaker banks tend to almost skip Stage 2 denomination and comment on their Stage 1 ‘quality’ and Stage 3 ‘controllable’ outstanding credit risk. In conclusion of the first point, current credit spreads on bank credit that must absorb losses are rather thin, as depositors, covered and senior preferred investors will almost never participate in a potential bank resolution or receivership, default event. Especially the stack of liabilities above bank AT1 and T2 debt is impressive. A small miscalculation on the quality of a bank’s assets can easily instil doubt on coupon treatment for AT1 or at worse the fate of T2 under resolution as coupons on T2 debt cannot be skipped. And here, the regulator and the banking sector meet each other. Why? Well, the regulator will prevent events that might cause contagion. I provide the reader with an example that occurred last week. A systemically important Italian bank decided to skip a quarterly coupon payment on a deeply subordinated debt instrument for reasons of an overall 2020 bank loss. Notwithstanding, coupon payments on AT1 instruments should not be at risk. The ECB induced dividend ban over 2020 drove the bank to change its articles, allowing 2020 payment of coupon even if no dividend was released. In the meantime, the bank also continues a share buy-back program whilst clearly interpreting the loss-absorption details across subordinated capital instruments as they see fit. A very disturbing event that could get reverberations when the next market shock present itself.
Most of the above regulation relates to the concept of predefined risk weights, standardised or through an internal ratings-based approach. The regulator states: “The less risky an asset, the lower its risk-weighting and the less capital is needed to cover for potential losses”. That exercise pushes RWA measured bank balance sheets to levels between EUR 50 billion up to EUR 850 billion. It provides the investor with a sense of security, as all legal capital requirements are expressed as a percentage of RWA and, indeed, are reassuring. However, I prefer to focus on leverage ratio. The leverage ratio measures a bank’s capital relative to its total assets. To what extent does a bank leverage its capital base in order to seek a certain return on equity. Here, return on assets for a bank is a key consideration. Global central banks’ QE efforts have reduced the expected return on fixed income and other assets. Suppose a bank that has a return on assets of 1.00% (combination of net interest income and income received across all other cash-flow-generating instruments minus the cost of risk). In order to reach a return on equity of 10%, the bank will need to leverage 10 times up. Actual return on assets for many banking players is well below 1.00%. At all times, the straightforward leverage ratio fights with the use of capital adequacy under an RWA framework (aka Cooke ratio). The leverage ratio across European banks sits, broadly speaking, between 3.5% and 6.5%. On this metric bank are still levered between 28 and 15 times. Applying the Cooke ratio, RWA methodology, leverage drops approximately towards a 5 to 7 times bracket. A world of difference. A simple Tier 1 leverage ratio of 5% means that a drop in upfront value of assets of 5% would wipe out total capital. Questions are put forward on the ESG quality or (lack thereof) of the bank loan book and overall asset profile. If we introduce the notion of stranded assets when assessing that risk across the bank’s balance sheet, eyebrows might be raised. A drop of 5%… The point is, understanding these metrics is essential in estimating the buffer provided by bank credit spreads.
And last but not least, there is overall bank model risk. The traditional banking model comes under increasing competitive stress from technology platforms. These platforms are able, once backed up by a banking license, to offer most banking services through a user-friendly set of apps. On the other hand, we must track developments in blockchain and central bank digital currencies. The threat is clearly visible across emerging markets where people in possession of 5-G smartphones can develop ‘banking relationships’ that would be unattainable if they had to go through the traditional bank account opening process.
Over the past week, US nominal rates behaved in a steady fashion. On the contrary, the action in real rates (US inflation-linked bonds) was dismal. 10-year real rates surged ahead and closed at -0.83% versus -0.92% on Friday May 14. The inflation-linked bond sector clearly fell victim to the adagio ‘buy the rumour, sell the fact’. After an unrelentless surge in inflation expectations since April 2020, the release of surprisingly high CPI and PPI numbers led to a profit taking stumble. Expect all focus and attention over the next couple of months to go towards inflation indicators, soft or hard. We’ll have another batch in three weeks’ time. Fact is that high inflation expectations are here to stay. At this moment inflation is priced through still deeply negative rates and nominal 10-year+ rates between 1.50% and 2.5%. It is an invitation to reflect on the sustainability and persistence of deeply negative real rates rather than the level of nominal rates.
The bleeding across European government rates came to a standstill. It seems that, at current valuations, the market is finding better supply-demand clearance conditions. The stress across Italian, Spanish and Portuguese government bonds abated. Markets will prepare for duration extensions into month-end. EGB’s took back 28bp in performance and closed at -4.07% since the start of 2021.
The European investment grade (IG) and high yield (HY) bond sector delivered mixed results. IG corporate bonds shed another 7bp whereas HY barely made it into positive territory at +4bp over the week. The rates’ tail is wagging the IG and HY dogs’ fate for the moment. Expect solid primary activity to unfold over the next month. Many corporates will want to frontload funding before the summer, as nervousness over higher rates towards H2 2022 is accelerating.
Emerging Market local debt performance was negative this week, with a -0.53% total return loss in EUR terms for a yield just below 5.00%. Currencies, when measured in EUR, showed a small negative return, with the Hungarian Forint (+1.80% in EUR Terms), Polish Zloty (+0.85%) and South African Rand (+0.80%) the winners and Chilean Peso (-3.40% in EUR terms) and Indonesia Rupee (1.70%) amongst the biggest losers.
On June 6, elections at various government levels (including the 500 members of the federal Chamber of Deputies and 15 state governors) will take place in Mexico. Currently, the party of the President (MORENA) and allies (PT, PES and PVEM) hold a 2/3rd majority in the chamber of Deputies but not in the Senate (61.7%). As only one senate seat is open for re-election, it will be impossible to reach the needed 2/3rd majority in the Senate to make changes to the constitution. In Mexico, there is, however, always a risk of ‘flipping’ senators (they would need 5). Senators elected for another party could be convinced to join MORENA. Additionally, a constitutional change needs the approval of a simple majority of the 32 states. Of the 17 states not-open for re-election, MORENA (5) and allies (1 for PES) hold 6. With polls showing 7 states for MORENA and 1 for its allies (PVEM/PT) the total would be 14. Special attention will hence go the ‘swing’ states of Guerrero and Michoacán. The National Electoral Institute (INE), which oversees Mexico’s elections, disqualified the MORENA candidates (both candidates were frontrunners) as some electoral procedures were not followed. Despite the bad management of the COVID-19 crisis, the tragic collapse of the Mexico City metro line and the struggle with high levels of insecurity, AMLO’s and MORENA’s approval ratings are still at very high levels.
We feared that a watering down of the tax reform in Colombia could trigger a downgrade in Colombia. Street protests, and unnecessary use of violence that killed at least 17 people, forced the Duque Government to withdraw the bill completely. In a rather surprise move with respect to timing, S&P cut the sovereign rating to BB+, below investment grade. It makes us reflect on the power and the role of rating agencies, as they insisted on a successful tax reform in order to preserve the investment grade rating of the country. The downgrade now, does not leave the option of a new proposal nor will it be helpful for a quick solution to end the street protests. Below Mexico, Colombia sovereign local currency bond yields had little value. Now, with spreads versus Mexico around 50bp in 10 years and around 70bp in 30 years, we think value has been created, especially with inflation expectations well-anchored around 3.25% by the end of 2021 and 30-year yields at 8.45%.
The good performance of the Hungarian Forint followed after Deputy Governor Barnabas Virag’s surprised the market with hawkish comments that Hungary must prepare for a hike of the base rate in June in response to increased inflation risks. The suggestion of a phase out of crisis-related measures was interpreted by the market as the end of the QE purchases on long-dated bonds. This will not be the case, for now, and refers rather to the phasing out of liquidity injections. With inflation at 5.10% and a policy rate at 0.60%, Hungary has one of the most negative real policy rates, so a more orthodox approach is positive news.
Bank credit spreads have surfed back towards pre-pandemic levels as tested, but supportive bank capital adequacy levels and prime Q1 2021 results turned into a homerun for bank funding costs. Banks enjoy highly accommodative funding conditions. Notwithstanding that overall short-term ECB funding occurs at -1.00% and public market funding costs are near historic lows, we ask ourselves if we are well protected? Do bail-in bank capital debt instruments provide enough spread remuneration given the quality of bank assets across mortgages, consumer credits, SME and large corporate credit lines next to the often-neglected portfolio of derivatives?
A real understanding of leverage in a business model built on the conversion of spreads into profits, is an essential criterion in order to separate the wheat from the chaff. On top, a correct apprehension of technology and platform disruption risk across banking models is paramount in avoiding stranded investment issues.