January was a relatively good month for our securities, despite the slight increase in interest rates at the beginning of the month. Following central banks’ announcements, market participants have been reviewing their assumptions regarding the timing of rate cuts, but the direction remains the same and the outlook remains positive and constructive ie, a gradual disinflationary scenario combined with a soft or no landing. Spreads within our securities tightened slightly during the month, on top of the high income we are receiving. However, spreads on subordinated debt of financials remain wide, especially on a relative basis. As such we believe that there is further upside in terms of capital appreciation, in addition to the high income we are receiving.
Valuations and Fundamentals
Financials are in a sweet spot. Banks have started to report Q4 earnings at the end of the month, the results remain solid. While the benefits from higher interest rates have largely materialised, the sector is now delivering strong returns (double-digit return on equity) that bode well for bondholders. Capital metrics remain at very strong levels, and asset quality trends show very limited signs of deterioration. As an example, Banco Santander reported a net profit of EUR 11.1 billion for the full year, up 18% year-overyear (YoY) (Q4 earnings up 28% YoY), a circa 15% return on tangible equity. Non-performing loans were roughly unchanged at 3.1%. This demonstrates that credit fundamentals of European financials remain extremely strong.
Technicals on subordinated debt of financials, notably for Additional Tier 1 (AT1) contingent convertible bonds (CoCos), continued to be positive. We saw a number of new AT1 issues during the month, which all attracted strong demand. Moreover, AXA reopened the Restricted Tier 1 (RT1) market with a EUR 1.5 billion issue, which was massively oversubscribed. That new issue came with a coupon rate of 6.375%. Whilst we did not consider this new issue to be particularly attractive with a spread of 384 basis points (bps), we think that it underscores the value we can find within other RT1’s where we can get significantly higher yields. This also makes us believe that prices on the secondary market have room for further appreciation. Approximately 40% 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 RT1s, corporate hybrids and callable Tier 2 bonds, 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 continued price appreciation. We believe this should benefit the fund going forward on top of the high income we are capturing.