Sentiment was strong in July. The theme of disinflation coupled with a soft landing made a comeback during the month. This was partially linked to the lower-than-expected inflation prints that we saw within the US and the UK. This meant that we saw spreads in general tighten, and more so within subordinated financial debt, to the benefit of securities we hold.
Valuations and Fundamentals
As stated above, spreads tightened during July. However, spreads remain at very wide levels historically and we believe this creates significant opportunities. For instance, spreads on GBP Additional Tier 1 (AT1) contingent convertibles (CoCos) are on average above 600 bps. In 2021, spreads on AT1 CoCos were between 250 and 300 basis points. As such, despite the current macroeconomic uncertainties, valuations are attractive and have significant room to tighten ie, for the prices of our securities to go up relative to government bonds. We are in the middle of Q2 earnings season and European and UK banks have been delivering very strong results. This was expected, as banks are benefitting from higher interest rates. As an example, BBVA reported a net profit of €2bn in Q2, which was up 11% yearon-year and 10% compared to Q1 – leading to a 16.9% return on tangible equity for the first half 2023
CET1 was around 40bps higher compared to end-22 at 13.0%, equivalent to ~€15bn of excess capital over regulatory requirements. The bank’s asset quality metrics remain sound with no signs of significant deterioration as Non-Performing Loans remain low at 3.4% and loan loss provisions were stable compared to Q1. Customer deposits were up 2% compared to end-22 at €402bn. And in spite of this, BBVA AT1’s still have very high yields.
We saw some more positive events within the subordinated debt markets. Three European banks called their AT1s, namely BBVA, CaixaBank and Barclays. For our part, as mentioned in previous comments, we expected all of these calls, and this was subsequently taken positively by the market, particularly following the Barclays call. Despite this, extension (or non-call) risk remains largely overstated; the AT1 market is still pricing close to 60% of the AT1s as if they will not be called, Marketing material for professional / institutional / accredited investors GAM Star Fund plc – GAM Star Credit Opportunities (GBP) despite the fact that less than 10% of AT1s have historically not been called. Moreover, a large part of the AT1 CoCos which remain to be called this year have already been pre-financed, meaning they are highly likely to be called. Within other parts of the subordinated debt market, such as Restricted Tier1s (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 currently, 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 see further strong recovery. As markets start normalising, we should continue seeing more recovery while still capturing high income.