Monthly comment
The month of August was softer for our securities. Inflation continues going down but remains too high for the central banks. Spreads on the subordinated debt of financials widened during the month and remain at very wide levels.
Valuations and Fundamentals
As stated above, spreads widened in August. Spreads remain at very wide levels historically and we believe this creates significant opportunities. For instance, spreads on Additional Tier 1 (AT1) contingent convertibles (CoCos) are still well above 500 basis points (bps). In 2021, spreads on AT1 CoCos were between 250 and 300 bps. As such, despite the current macroeconomic uncertainties, valuations are attractive and have significant room to tighten ie, for the prices of our securities to go up relative to government bonds. We have finished the Q2 earnings season and European and UK banks and insurances delivered very strong results. Banks continue to benefit from higher interest rates. Moreover, stress test results during the summer demonstrated the resilience of banks should an adverse macroeconomic scenario develop.
Subordinated Debt
We saw some more positive events within the subordinated debt markets. Société Générale called an AT1. We also saw Banco Santander skip a call. However, this was very much expected as Banco Santander have always said economics are the main driver for call decisions. Moreover, the bond in question is callable every quarter, which means there is a high likelihood that it will be called within the next quarters especially as the coupon will increase from 5.25% to 8.2%. The new issue market for AT1s continued to reopen and we saw very strong demand for new issues. This is positive and should help the prices of our securities to go up going forward. Extension (or non-call) risk remains largely overstated; the AT1 market is still pricing more than 60% of the AT1s as if they will not be called, despite the fact that less than 10% of AT1s have historically not been called. Moreover, a large part of the AT1 CoCos which remain to be called this year have already been pre-financed, meaning they are highly likely to be called. Within other parts of the subordinated debt market, such as Restricted Tier 1s (RT1s), corporate hybrids and callable Tier 2s, we also see this extension risk as being largely overstated. 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 further recovery. As markets start normalising, we should continue seeing more recovery while still capturing high income.
