Monthly comment
Markets in June were characterised by the higher interest rates for longer theme following a number of macroeconomic data releases. As such, we saw some strong moves upwards in government bond rates, most notably among short-dated rates as seen in the two-year rates moves. This was further accentuated within the UK, where we saw a strong inflation print which led the Bank of England (BoE) to increase its base rate by 50 basis points (bps). Spreads within our securities tightened during the month, however that only slightly compensated for the move higher in interest rates. UK issuers and GBP denominated securities were more affected from a price perspective due in part to the larger move in generic interest rates.
Valuations and Fundamentals
As stated above, spreads have tightened during the month. However, spreads remain at very wide levels historically and we believe this creates strong opportunities. For instance, spreads on Additional Tier 1 (AT1) contingent convertibles (CoCos) are on average around 600 bps and closer to 700 bps within GBP denominated securities. In 2021, spreads on AT1 CoCos were between 250 and 300 bps. As such, despite the macroeconomic uncertainties, valuations are attractive and have significant room to tighten ie, for the prices of our securities to go up. Moreover, credit fundamentals for European banks remain at strong levels. Common Equity Tier 1 (CET1) ratios remain very high. Profitability of banks also remains high, and deposits have, on aggregate, remained very stable within European institutions. We believe that over time investors will regain confidence to invest within financials. Regarding the UK, there have been concerns regarding mortgage loans due to the moves in interest rate. However, it is important to note that UK banks have been extremely stringent in terms of giving loans to households. For instance, UK banks have been doing affordability tests based on scenarios where rates increased by 3%. This should mitigate loan losses. Moreover, loan losses on mortgages are usually strongly correlated with unemployment, which is currently at very low levels within the UK.
Subordinated Debt
We have seen some positive events within the subordinated debt markets. Following a number of Tier 2 bonds being issued in the last two months, we saw the first AT1 issued by a major European bank, namely BBVA. They issued EUR 1 billion of an AT1 with a coupon of 8.375%. There was strong demand for this new issue. Despite that, extension risk remains largely overstated. Close to 80% of the AT1 market is still pricing extension risk. This is despite the fact that more than 95% of AT1s have historically been called. Moreover, a large part of the AT1 CoCos which are callable 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 Tier 1s (RT1s), corporate hybrids and callable Tier 2’s, 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 strong recovery. As markets start normalising, we should see some recovery while continuing to capture high income.
