Macro Backdrop
Sentiment was mixed in February, as credit spreads in general finished the month at relatively similar levels. Following the postponement of the Canada and Mexico tariffs proposed by President Trump, spreads tightened during the first part of the month. However, spreads subsequently widened as geopolitical tensions, notably related to tariffs, weighed on markets. Moreover, we saw US and European interest rates diverge as weak macro prints in the US led US Treasury rates to fall significantly, while European government bond rates fell only slightly as there were concerns over higher defense spending. Spreads within Additional Tier 1 (AT1) Contingent Convertible bonds (CoCos) hit historical tights during the month at 256 basis points (bps). Credit spreads in general remain at relatively tight levels compared to historically, but the ‘all in’ yields remain attractive, especially when looking at the last 10 years. These yields mean that technicals within credit markets have remained very strong.
Valuations and Fundamentals
As stated above, spreads within credit markets are at the tighter end of historical values. While this could be justified by fundamentals, we know credit markets tend to be cyclical. As such, we believe some caution is warranted. Moreover, extension risk, which looks at the percentage of AT1 CoCos priced to perpetuity or call, remains below 10%. When market conditions are poor it tends to peak at 100% and when market conditions are very strong, as at present, this percentage tends to approach 0%, indicating that valuations are at their tightest. As such, from a risk-return perspective, we believe there is currently more value in Tier 2 and senior bonds from financials.
The majority of banks have published Q4 earnings, coming in above consensus expectations on average – while credit metrics remain very strong. As an example, NatWest reported an operating profit of GBP 1.5 billion in Q4, up 19% year-on-year, and equivalent to a 19% return on tangible equity – beating consensus expectations. The group’s Common Equity Tier 1 (CET1) capital ratio was up 20 bps in 2024 to 13.6%, or 310 bps / GBP 5.7 billion above regulatory requirements. Asset quality remained highly resilient, with very low loan loss
provisions in 2024 of 9 bps (as % of loans) and non-performing loans (NPLs) of 1.6%. Looking ahead, the sector’s fundamentals are expected to remain very strong, forecast to deliver a circa 11% return on equity in 2025 and 2026.
Subordinated debt
There were seven new AT1 issues in February. Those represented approximately USD 10 billion of issuance and we saw demand of approximately USD 60 billion. As we can see, market technicals remain very strong. However, the latest new issues came at relatively tight levels, which also means the resets are at tight levels. We know the low-reset bonds (such as the new issues) tend to be more volatile, and as such we did not think they were interesting.
