Macro Backdrop
December was a mixed month for risk assets. The month started relatively strongly for our securities and the lower than expected US CPI data for the second month in a row helped. However, sentiment turned more fragile following hawkish statements by the European Central Bank (ECB) and the Federal Reserve (Fed). The ECB surprised with the announcement of quantitative tightening, starting in March 2023. Interest rates went up significantly during the month to put an end to a complicated year for fixed income. Our fund is well positioned by notably being mainly invested within financials which tend to benefit from higher interest rates.
Valuations and Fundamentals
Despite seeing the beginning of a recovery in prices during the last quarter of the year, we believe valuations are attractive, as spreads have widened significantly during 2022. Spreads on a large part of subordinated debt of financials widened by more than 200 bps. This is despite the fact that credit fundamentals of financials remain strong. Non-performing loans (NPLs) for European and UK banks are currently at all-time lows, and capital ratios remain close to all-time highs for both banks and insurances. Moreover, higher interest rates mean higher net interest income (NII) for banks, which will likely translate into higher profitability and return on equity. This should outweigh any increase in NPLs resulting from the macroeconomic uncertainty. As such, we believe we are well positioned to recover the downward moves of 2022. As we have seen in the past, the fund has tended to recover within the following 12 months. We believe the strong income the fund is generating should help us going forward.
Subordinated debt
We are capturing high income. As an example, Barclays 6.375% Perp currently has a yield to next call in 2025 of more than 9.4%. We also observe that a large part of the subordinated debt market is still pricing extension risk, in spite of the fact that additional tier 1 (AT1), restricted tier 1 (RT1) and corporate hybrids are perpetual bonds which have call dates and a strong track record to be called at first call date. This was confirmed by UBS, which called the UBS 5% AT1 contingent convertible (CoCo). This was a strong message from an issuer and was in line with what we had seen in the past from core issuers. For instance, Credit Suisse and Barclays had refinanced AT1’s at higher costs in June 2022. We therefore believe that extension risk is overstated. During risk-off environments such as in 2022, callable perpetual bonds tend to reprice to maturity, creating a double-negative effect on prices. However, the opposite is true too, ie when markets begin to normalise, spreads of those bonds start to tighten, leading to a repricing to next call date and sequentially creating a double-positive effect on prices. As a majority of our bonds are pricing the extension risk, we believe they should benefit going forward as valuations tighten. In the meantime, we are receiving considerably high income.
