Market Backdrop
January was a strong month for risk assets. Spreads on our securities tightened and government bond rates fell during the month, therefore prices on our securities benefitted strongly. All of this was related to the expectations of a softer monetary policy from most major central banks. The latest US CPI number, as well as the positive developments regarding the energy crisis in Europe helped that narrative of potentially less hawkish central banks. Moreover, technical factors seem to be strong, as we have seen secondary markets perform very strongly despite a heavy January in terms of new bond issuance.
Valuations and Fundamentals
We are currently in a continuation of the recovery in spreads and prices which started in October. However, spreads on subordinated debt of financials are still significantly wider than where they were one year ago. We have also just started Q4 earnings season and credit fundamentals of financials remain extremely strong. For banks, we expect to continue seeing the trend of increasing net interest income (NII), because of higher interest rates. This should outweigh any increase in non-performing loans (NPLs) resulting from the macroeconomic uncertainty. Moreover, the latest statistic by the European Central Bank (ECB) regarding NPL’s was the lowest level since the ECB started collecting this data. We believe the fund is well positioned to recover the downward moves of last year. Moreover, in the past, the fund has tended to recover from a drawdown within the next 12 months. We believe the end of the drawdown was in October last year, and as such expect our securities to perform strongly going forward. Furthermore, the strong income we are receiving should help us going forward.
Subordinated Debt
We are capturing high income, with many securities still having yields above 8%. We also observe 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 HSBC and Banco de Sabadell, which both called their AT1 contingent convertibles (CoCos) during the month of January. This was a strong message from issuers and was in line with what we had seen in the past from core issuers, such as UBS, which called the UBS 5% in December. Other examples are Credit Suisse and Barclays which had refinanced AT1s at higher costs in June 2022. We therefore believe that extension risk is still 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. This has started happening, but there are still a number of bonds pricing extension risk, and as such we believe they should benefit as valuations tighten.
