Macro Backdrop
Markets finished the month strongly after a slightly weaker start. Trade tensions, the US government shutdown, French political risk and worries around the US regional banking sector weighed on sentiment in the first half of the month. However, as trade headlines turned positive, these worries eased and the technicals regained dominance, pushing bond spreads tighter. In the second half of the month, markets also turned stronger on the back of robust Q3 earnings, notably alleviating concerns around US regional banks.rd.
Valuations and Fundamentals
As stated above, spreads initially widened before tightening again, finishing the month close to the historical tights. As an example, spreads within Additional Tier 1 (AT1) contingent convertible bonds (CoCos) widened to 277 basis points (bps) before finishing the month at 254 bps. This is close to the tightest historical levels seen on AT1 CoCos. Credit quality of financials has improved significantly over the last 10 years, when looking at capital ratios and leverage ratios. Therefore, this could justify tighter spreads on AT1 CoCos and subordinated debt of financials. However, we know that markets and AT1 CoCos are cyclical. We have often seen spreads widen during those periods, despite the strong credit quality.
Extension risk, which looks at the percentage of AT1 CoCos priced to perpetuity or call, is currently at 4%, which is also close to all-time lows. When market conditions are poor it tends to peak at 100% and when market conditions are very strong, this percentage tends to approach 0%, indicating that valuations are at their tightest. We believe that all of these indicators warrant some caution. During the mini-market selloff in April, this helped us have low volatility and gave us opportunities to add to AT1 CoCos. Given current valuations, we believe that the April drawdown could serve as a warning regarding what can happen should markets sell off more severely.
The majority of European banks have reported Q3 earnings – another very strong quarter in which the majority came above consensus estimates, while capital and asset quality remained rock-solid. As an example, NatWest reported a net profit of GBP 1.6 billion in Q3, approximately a 25% beat relative to consensus. Moreover, the bank’s Common Equity Tier 1 (CET1) ratio was up 60 bps on the quarter to 14.2%, with excess capital of more than GBP 7 billion above requirements.
Subordinated Debt
Market technicals remain strong. With many banks in blackout ahead of Q3 earnings, AT1 issuance was limited in October. However, we did see three new Restricted Tier 1s (RT1s) being issued with very strong demand. A positive development during the month was the ruling by a Swiss Federal Administrative Court that the write-down of Credit Suisse (CS) AT1 bonds was unlawful. While the judgment currently did not order a reversal and has been appealed by the Swiss Financial Market Supervisory Authority (FINMA) and UBS to the Swiss Supreme Court, it increases the likelihood that CS AT1 holders could receive compensation. However, there remains material uncertainty and the appeals process will be lengthy. Finally, even if bondholders are compensated, it is unclear how much this would be. As such, this is a positive development for CS AT1 holders, but the situation remains highly complex.
