Monthly comment
Like November, December was a very strong month for risk assets. This came following some positive macroeconomic data and the Fed’s dovish comments that seemed to pave the way for a gradual disinflation scenario combined with a soft or no landing. This was obviously taken positively by global markets and has also meant that spreads on our securities have tightened, on top of the benefits of interest rates falling. This being said, spreads on subordinated debt of financials remain wide, especially on a relative basis. As such we believe that there is more upside potential in terms of capital appreciation, in addition to the high income we are receiving.
Valuations and Fundamentals
Financials are in a sweet spot, in our view. They continue to benefit from the elevated interest rate environment, and this has resulted in higher profitability. While spreads on subordinated debt of financials tightened during the month, a lot of this tightening was in line with the strong performance we saw on global markets. Therefore, on a relative basis also, subordinated debt of financials remains extremely attractive. As an example, we are getting significantly greater yields than high yield debt. This is even though most of the issuers we own are investment grade companies, and even going into a recession these credits should be significantly more resilient, as demonstrated in the past.
Subordinated Debt
Technicals on subordinated debt of financials, notably for Additional Tier 1 (AT1) Contingent Convertibles (CoCos), continued to be extremely positive. On top of that, we saw other supportive developments, such as Banco Santander calling the AT1 bond that they had not called during the summer. Therefore, this has meant that all the AT1s of national champions which had a call date in 2023 were called. This is in line with what we have seen historically. Currently more than 40% of the AT1 CoCo market is still priced to perpetuity. The experience of 2023, when all national champions called their bonds, shows the extent to which extension (or non-call) risk remains largely overstated. 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 earlier this year, 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 continue seeing further price appreciation. We believe this should benefit the fund going forward, on top of the high income we are capturing.
