Looking for Value in High Income Credit

Additional Tier 1 (AT1) debt has lost ground versus European High Yield (EHY) debt so far in 2018, with spread differentials currently exceeding 50 bps. The team at Atlanticomnium explain that this not only raises questions about the drivers behind the underperformance of bank AT1s, but also considerations about how risky they are compared to EHY debt. Overall, they find value in both AT1s and EHY, but believe AT1s offer more attractive yields with lower fundamental risk, especially in the context of deleveraging in the European banking sector and a continued trend of improving balance sheets.

Originally Published by GAM on 19 September 2018

After an impressive run in 2017, where Additional Tier 1 (AT1) debt returned more than 13%, 2018 has been more volatile and AT1s have underperformed European High Yield (EHY) debt year to date. This has been driven by the general weakness of risky assets, as well as AT1-specific factors. Heightened geopolitical risk (trade wars, populism, Brexit, emerging markets, etc), combined with a gradual shift towards monetary policy tightening by the European Central Bank, have pressured European capital markets. As a non-standard risk asset class (a perpetual structure with loss absorbing mechanisms) and with a less established investor base (under a decade of trading history), AT1s have proven to be sensitive to market sentiment.

Current valuations (Data as of 10/09/2018)

Source: Bloomberg, based on Bloomberg Barclays Contingent Capital EUR Total Return Index Value Unhedged and Bloomberg Barclays Pan-European High Yield (Euro) TR Index Value Unhedged as at 10 September 2018.

Past performance is not indicative of future performance. Indices cannot be purchased directly.

Chart 1: Performance of EUR Banks AT1s and EHY

Source: Bloomberg, based on Bloomberg Barclays Contingent Capital EUR Total Return Index Value Unhedged and Bloomberg Barclays Pan-European High Yield (Euro) TR Index Value Unhedged as at 13 September 2018.

Past performance is not indicative of future performance. Indices cannot be purchased directly.

Extension risk has also been a driver of AT1 returns. Extension risk refers to the fact that an AT1 is either called at par, after the requisite number of years, or the coupon can be reset for a further period. As spreads widen demand from those investors who buy on the expectation the bond will be called at a specific date lessens. In our view, spreads are more likely to narrow going forward, but concerns regarding extension risk have affected market prices so far this year

 

Source: Bloomberg, based on Bloomberg Barclays Contingent Capital EUR Average OAS and Bloomberg Barclays Pan-European High Yield (Euro) Average OAS as at 13 September 2018.

Past performance is not indicative of future performance.

While price volatility has affected AT1s more than EHY, and remains a key risk for the asset class, we view the fundamental risk of AT1s to be lower than EHY. Bond investors generally break down risks into two major categories: credit risk (risk of default) and duration risk (risk linked to changes in interest rates). On top of this, we add liquidity risk.

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