Monthly comment
February was a relatively stable month for our securities, despite the increase in interest rates. Spreads on our securities tightened slightly during the month. The macroeconomic data has meant that market participants have been revising their assumptions on the number of rate cuts in 2024 downwards. However, the outlook remains constructive, i.e. a gradual disinflationary scenario combined with a soft or no landing. Spreads on subordinated debt of financials remain wide, especially on a relative basis. As such we believe that there is more upside in terms of capital appreciation, in addition to the high income we are receiving.
Valuations and Fundamentals
We have been through Q4 earnings seasons, and the results have remained solid. The banking sector delivered strong Returns on Equity (RoE) of close to 12% in 2023. While there are concerns that we might have reached “peak earnings”, the banking sector is still expected to deliver strong RoE of 10%-12% over the next two years, which is very supportive for bondholders. During February, we have once again seen concerns regarding the exposure to Commercial Real Estate (CRE), notably in the US. Exposure to CRE is very limited for European banks, and highly concentrated in a few specialist institutions, such as PBB in Germany. We do not have exposure to any of these institutions. Moreover, large European banks have limited exposure to CRE in general (roughly 5-10%), a factor that limits the impact of losses starting to materialise – a mere earnings headwind, even in the worst case. Finally, capital metrics for European banks remain near record-high levels. As such, we remain very positive on the credit fundamentals of European and UK national champions.
Subordinated Debt
Technicals on subordinated debt of financials, notably for Additional Tier 1 (AT1) contingent convertible bonds (CoCos), remain positive. There have been several AT1 issues during the month where there was strong demand, and which did not necessarily come with a new issue premium. Nevertheless, we believe there is more value in the secondary market and prices have a lot more room to continue rising. Approximately 35% of the AT1 CoCo market remains priced to perpetuity. As such, 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 early 2023, 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 price appreciation. We believe this should benefit the fund going forward.
