Macro Backdrop
We saw calmer markets in April, following the strong volatility we experienced in March. The direction of markets seems to be largely guided by the upcoming central bank meetings and future macroeconomic data. Despite the continued woes of First Republic Bank in the US, markets seemed to have moved on from the banking crisis. We believe that investors understand that US regional banks and Credit Suisse are two idiosyncratic events, which do not have any read across to the current credit fundamentals of other national champion banks in Europe and the UK.
Valuations and Fundamentals
We saw positive performance in April, which is largely linked to the income we have been receiving. Spreads on subordinated debt of financials have remained relatively stable, after having significantly widened in March. As such we believe valuations are at attractive levels. Moreover, we are in the middle of Q1 earnings season and for the moment we have seen strong results from European banks. Common Equity Tier 1 (CET1) ratios remain at very high levels and the profitability of banks remains strong. In terms of bank deposit flows, on aggregate these have been stable, and we have not seen any European national champions experience large deposit outflows, with some even experiencing inflows. We believe that over time, investors will regain confidence investing within financials, as credit fundamentals remain at strong levels and higher interest rates translate into higher profitability. This higher profitability should mitigate any increase in non-performing loans (NPLs). In the meantime, the fund is receiving strong income, and that should be a factor that helps us going forward.
Subordinated debt
We saw some positive events within the subordinated debt markets in April, namely that UniCredit and Lloyds have both called Additional Tier 1 (AT1) contingent convertibles (CoCos). These calls demonstrate that extension risk is largely overstated. More than 90% of the AT1 market is still pricing extension risk (ie non-call risk), despite the fact that more than 95% of AT1s have historically been called. Furthermore, a large part of the AT1 CoCos which are callable this year have already been pre-financed, meaning that they are likely to be called. Within other parts of the subordinated debt markets, such as Restricted Tier 1s (RT1s), corporate hybrids and callable Tier 2s, we also see this extension as being largely overstated. As we have often pointed out, during risk-off environments such as in 2022 and currently, callable perpetual bonds tend to reprice to maturity, creating a double-negative effect on prices. However, the reverse is true when markets are stronger, and as such we expect to see strong recovery while continuing to capture high income. As an example, Barclays’ 6.375% Perpetual is currently trading around 86% which means a yield to maturity of close to 10.5%, but a yield to call of more than 13%.
