Macro Backdrop
Markets remained constructive in August. The month started with weaker employment numbers in the US. As such, the market focus shifted to the potential for interest rate cuts in the US. Jerome Powell’s speech at Jackson Hole seemed to be going in that direction. However, the potential firing of Lisa Cook from the Federal Reserve (Fed) has put central bank independence back in the spotlight. This created some volatility. Moreover, the announcement of a Vote of Confidence regarding the government in France has created some uncertainty, and this weighed a bit on French assets. However, market technicals have remained very strong and as such credit spreads remain at or close to historical tights. For instance, spreads on Additional Tier 1 (AT1) contingent convertible bonds (CoCos) tightened to 248 basis points (bps) during the month, marking the tightest levels on record, before widening to 271 bps by the end of the month. This reflects that a lot of positive news is already priced in, we believe some caution is warranted going forward.
Valuations and Fundamentals
As stated above, credit spreads have tightened to record lows during August, before widening in the second half of the month. Extension risk, which looks at the percentage of AT1 CoCos priced to perpetuity or call, remains very low at 5%, close to historical lows. When market conditions are poor, this metric tends to peak at 100%, and when market conditions are strong, this percentage tends to approach 0%, indicating that current valuations are at their tightest. As such, in current market conditions, it is important to focus on higher-quality bond structures, ie, AT1 CoCos issued by high quality banks with large resets spreads. These bonds are very likely to be called irrespective of market conditions and tend to have less drawdown in a market downturn, while still offering attractive yields. The tightest historical level for AT1 CoCos occurred on the 18 February. From that date until 9 April, which marked the lowest point of the subsequent selloff, our fund declined by -2.63%, compared to -4.22% for USD AT1 CoCos. Given current valuations, we believe that the April drawdown could serve as a warning regarding what can happen should markets experience a more severe correction. We have now reached the end of Q2 earnings season, and results remain very strong. Most banks released in line or above consensus figures, and we saw a number of issuers upgrading their full-year guidance. On top of them reporting better revenues, asset quality remains robust, as Non-Performing-Loans remain at very low levels. Moreover, capital ratios remain at high levels, reinforcing the fundamental strength of the sector.
Subordinated debt
Market technicals remain very strong, with limited new issuance in August, as expected. However, interestingly, we saw Allianz issue a new Restricted Tier 1 (RT1) instrument to refinance an existing RT1 which had been tendered. There was more than USD 12 billion of demand for this USD 1.25 billion Allianz RT1, which came at 6.55%. This represents a spread of 232 bps. The strong demand was surprising, since Allianz has always been very clear that they have an “economic” focused approach when calling bonds. Given the low reset spread on this RT1 (232 bps), there is a risk that this bond may not be called in the future, and we know perpetual bonds with low resets are weaker structures. Those tend to have larger drawdowns during a market downturn. However, market participants seem to be complacent about this risk, and we actually saw this new issue perform strongly in the secondary market. This once again demonstrates the resilience of market technicals and that there is a very strong focus on yields, rather than spreads.
