GAM Star Credit Opportunities (EUR)

Markets were challenging during the month of March, driven by the economic ramifications of the Covid-19 outbreak. This has led to a sharp sell off during the first half of the month in subordinated debt markets and wider credit and equity markets more generically. Sentiment improved during the second part of the month as central banks, governments and regulators all took extraordinary measures to support the economy through this period of uncertainty.

While the prices of our bonds have been negatively impacted by the sell off, the credit quality of our issuers continues to be extremely strong, as reflected by the average rating of BBB+ at the issuer level. Financials remains one of the strongest sectors within credit markets, and, in our view, they are able to pursue their role of lending to the real economy and being part of the solution (compared to being part of the problem during the global financial crisis (GFC)). Since the GFC, very strict regulation has led to extremely strong capitalisation levels and very strong de-risking of the banking system. The outcome is reflected in the results of the stress test, where banks are able to sustain an apocalypse scenario worse than the GFC with average capital ratios of 10%, or around twice the level of capital pre-crisis. Clearly beyond a small number of sectors, the current situation for corporates (especially large corporates) is a liquidity issue rather than a solvency issue. As governments and central banks have been committed to supporting these institutions during this period, through buying commercial paper or providing government guarantees on bank lending, the impact for banks’ asset quality should ultimately be limited. Central banks and governments have shown their willingness to do “whatever it takes” to support the economy, with unprecedented monetary and fiscal stimulus.

The European Central Bank (ECB) issued a recommendation to European banks to refrain from paying dividends to shareholders, as well as to conduct share buybacks, at least until 1 October 2020. This is in line with previous communication that banks need to fulfil their social duty to keep all available resources in order to maximise their support to their clients in times of uncertainties. This decision has no impact on payment of interests made on AT1 CoCos, Tier 2 bonds, as well as preference shares, but will impact the income on the 6.5% Rabobank Perp held in the fund, as this security has been issued as an CET1 instrument (as in, equity and not an AT1 instrument). We therefore continue to see strong visibility on the income captured by the fund.

Given the sell off seen in markets, valuations are extremely attractive and we are able to capture spreads of close to 800 bps. Furthermore, markets have become dislocated, with indiscriminate selling across the capital structure. This has created significant buying opportunities, especially as virtually all of the subordinated financials market is trading to perpetuity – with large upside for bondholders on a re-pricing to call. Furthermore, several specific instruments have been heavily impacted by the sell-off, irrespective of the characteristics of the bonds. For example, RBS’s legacy perpetual floating-rate notes (FRNs) in USD (paying a coupon of Libor +232

bps) has fallen by 16% YTD and is now yielding 14% to a call in December 2021 (close to 1300 bps of spread), at which point the bonds lose all capital value and become expensive funding for the bank. Overall, the re-pricing of bonds to perpetuity reflects the overselling and can therefore be an attractive entry point into the asset class.

Spotlight: Supportive regulatory position

Recent actions undertaken by regulators are supportive
to bond holders, ie access to cheap liquidity, capital relief, relaxation of accounting rules related to non-performing loans (NPLs) as well as state aid rules. Furthermore, regulators have asked banks to temporarily refrain from paying dividends to shareholders (including share buybacks), which means more retained earnings, even higher levels of CET1 and bigger buffers to maximum distributable amounts, which are all extremely supportive for subordinated debt holders.

This is somewhat counterintuitive but refraining banks from paying dividends to shareholders is actually very supportive for bond holders, including subordinated debt bondholders.

Why do regulators want to refrain banks from paying dividends to shareholders?

• Banks can pay and are in a strong position, ie excess regulatory capital, clean balance sheets, excess liquidity requirements.
• Not distributing dividends now means higher retained earnings and more capital which increases banks’ ability to lend and support the economy

• Dividends are discretionary but actually “cumulative”, ie if a dividend is not paid now, it can be paid at a later stage
• As a rule of thumb, EUR 1 billion of dividends is the equivalent of EUR 10 billion of lending capacity

Why we feel that coupons on AT1 CoCos are safe:

Andrea Enria, head of the ECB’s banking supervisory board, told investors during a Bloomberg interview that the ECB
does not plan to suspend coupons on AT1s and that banks are currently “very far” from breaching levels that would lead to coupons suspensions – reflecting the very strong fundamentals of the sector. This has already been confirmed by several banks.

GAM Star Credit Opportunities (GBP)

Markets were challenging during the month of March, driven by the economic ramifications of the Covid-19 outbreak. This has led to a sharp sell off during the first half of the month in subordinated debt markets and wider credit and equity markets more generically. Sentiment improved during the second part of the month as central banks, governments and regulators all took extraordinary measures to support the economy through this period of uncertainty.

While the prices of our bonds have been negatively impacted by the sell off, the credit quality of our issuers continues to be extremely strong, as reflected by the average rating of BBB at the issuer level. Financials remains one of the strongest sectors within credit markets, and, in our view, they are able to pursue their role of lending to the real economy and being part of the solution (compared to being part of the problem during the global financial crisis (GFC)). Since the GFC, very strict regulation has led to extremely strong capitalisation levels and very strong de-risking of the banking system. The outcome is reflected in the results of the stress test, where banks are able to sustain an apocalypse scenario worse than the GFC with average capital ratios of 10%, or around twice the level of capital pre-crisis. Clearly beyond a small number of sectors, the current situation for corporates (especially large corporates) is a liquidity issue rather than a solvency issue. As governments and central banks have been committed to supporting these institutions during this period, through buying commercial paper or providing government guarantees on bank lending, the impact for banks’ asset quality should ultimately be limited. Central banks and governments have shown their willingness to do “whatever it takes” to support the economy, with unprecedented monetary and fiscal stimulus.

The European Central Bank (ECB) issued a recommendation to European banks to refrain from paying dividends to shareholders as well as to conduct share buybacks, at least until 1 October 2020. This is in line with previous communication that banks need to fulfil their social duty to keep all available resources in order to maximise their support to their clients in times of uncertainties. This decision has no impact on payment of interests made on AT1 CoCos, Tier 2 bonds as well as preference shares but will impact the income on the 6.5% Rabobank Perp held in the fund, as this security has been issued as an CET1 instrument (as in, equity and not an AT1 instrument). We therefore continue to see strong visibility on the income captured by the fund.Given the sell off seen in markets, valuations are extremely attractive and we are able to capture spreads above 800 bps. Furthermore, markets have become dislocated, with indiscriminate selling across the capital structure. This has created significant buying opportunities, especially as virtually all of the subordinated financials market is trading to perpetuity – with large upside for bondholders on a re-pricing to call. Furthermore, several specific instruments have been heavily impacted by the sell off, irrespective of the characteristics of the bonds. For example, RBS’s legacy perpetual floating-rate notes (FRNs) in USD (paying a coupon of Libor +232 bps) has fallen by 16% YTD and is now yielding 14% to a call in December 2021 (close to 1300 bps of spread), at which point the bonds lose all capital value and become expensive funding for the bank. Overall, the re-pricing of bonds to perpetuity reflects the overselling and can therefore be a very attractive entry point into the asset class.

Spotlight: Supportive regulatory position

Recent actions undertaken by regulators are supportive
to bond holders, ie access to cheap liquidity, capital relief, relaxation of accounting rules related to non-performing loans (NPLs) as well as state-aid rules. Furthermore, regulators have asked banks to temporarily refrain from paying dividends to shareholders (including share buybacks), which means more retained earnings, even higher levels of CET1 and bigger buffers to maximum distributable amlunts, which are all extremely supportive for subordinated debt holders.

This is somewhat counterintuitive but refraining banks from paying dividends to shareholders is actually very supportive for bond holders, including subordinated debt bondholders.

Why do regulators want to refrain banks from paying dividends to shareholders?

• Banks can pay and are in a strong position, ie excess regulatory capital, clean balance sheets, excess liquidity requirements.
• Not distributing dividends now means higher retained earnings and more capital which increases banks’ ability to lend and support the economy

• Dividends are discretionary but actually “cumulative”, ie if a dividend is not paid now, it can be paid at a later stage
• As a rule of thumb, EUR 1 billion of dividends is the equivalent of EUR 10 billion of lending capacity

Why we feel that coupons on AT1 CoCos are safe:

Andrea Enria, head of the ECB’s banking supervisory board, told investors during a Bloomberg interview that the ECB
does not plan to suspend coupons on AT1s and that banks are currently “very far” from breaching levels that would lead to coupons suspensions – reflecting the very strong fundamentals of the sector. This has already been confirmed by several banks.

GAM Star Credit Opportunities (USD)

Markets were challenging during the month of March, driven by the economic ramifications of the Covid-19 outbreak. This has led to a sharp sell off during the first half of the month in subordinated debt markets and wider credit and equity markets more generically. Sentiment improved during the second part of the month as central banks, governments and regulators all took extraordinary measures to support the economy through this period of uncertainty.

While the prices of our bonds have been negatively impacted by the sell off, the credit quality of our issuers continues to be extremely strong, as reflected by the average rating of BBB+ at the issuer level. Financials remains one of the strongest sectors within credit markets, and, in our view, they are able to pursue their role of lending to the real economy and being part of the solution (compared to being part of the problem during the global financial crisis (GFC)). Since the GFC, very strict regulation has led to extremely strong capitalisation levels and very strong de-risking of the banking system. The outcome is reflected in the results of the stress test, where banks are able to sustain an apocalypse scenario worse than the GFC with average capital ratios of 10%, or around twice the level of capital pre-crisis. Clearly beyond a small number of sectors, the current situation for corporates (especially large corporates) is a liquidity issue rather than a solvency issue. As governments and central banks have been committed to supporting these institutions during this period, through buying commercial paper or providing government guarantees on bank lending, the impact for banks’ asset quality should ultimately be limited. Central banks and governments have shown their willingness to do “whatever it takes” to support the economy, with unprecedented monetary and fiscal stimulus.

The European Central Bank (ECB) issued a recommendation to European banks to refrain from paying dividends to shareholders as well as to conduct share buybacks, at least until 1 October 2020. This is in line with previous communication that banks need to fulfil their social duty to keep all available resources in order to maximise their support to their clients in times of uncertainties. This decision has no impact on payment of interests made on AT1 CoCos, Tier 2 bonds as well as preference shares but will impact the income on the 6.5% Rabobank Perp held in the fund, as this security has been issued as an CET1 instrument (as in, equity and not an AT1 instrument). We therefore continue to see strong visibility on the income captured by the fund.Given the sell off seen in markets, valuations are extremely attractive and we are able to capture spreads close to 650 bps. Furthermore, markets have become dislocated, with indiscriminate selling across the capital structure. This has created significant buying opportunities, especially as virtually all of the subordinated financials market is trading to perpetuity – with large upside for bondholders on a re-pricing to call. Furthermore, several specific instruments have been heavily impacted by the sell-off, irrespective of the characteristics of the bonds. For example, RBS’s legacy perpetual floating-rate notes (FRNs) in USD (paying a coupon of Libor +232bps) has fallen by 16% YTD and is now yielding 14% to a call in December 2021 (close to 1300 bps of spread), at which point the bonds lose all capital value and become expensive funding for the bank. Overall, the re-pricing of bonds to perpetuity reflects the overselling and can therefore be a very attractive entry point into the asset class.

Spotlight: Supportive regulatory position

Recent actions undertaken by regulators are supportive
to bond holders, ie access to cheap liquidity, capital relief, relaxation of accounting rules related to non-performing loans (NPLs) as well as state-aid rules. Furthermore, regulators have asked banks to temporarily refrain from paying dividends to shareholders (including share buybacks), which means more retained earnings, even higher levels of CET1 and bigger buffers to maximum distributable amlunts, which are all extremely supportive for subordinated debt holders.

This is somewhat counterintuitive but refraining banks from paying dividends to shareholders is actually very supportive for bond holders, including subordinated debt bondholders.

Why do regulators want to refrain banks from paying dividends to shareholders?

• Banks can pay and are in a strong position, ie excess regulatory capital, clean balance sheets, excess liquidity requirements.
• Not distributing dividends now means higher retained earnings and more capital which increases banks’ ability to lend and support the economy

• Dividends are discretionary but actually “cumulative”, ie if a dividend is not paid now, it can be paid at a later stage
• As a rule of thumb, EUR 1 billion of dividends is the equivalent of EUR 10 billion of lending capacity

Why we feel that coupons on AT1 CoCos are safe:

Andrea Enria, head of the ECB’s banking supervisory board, told investors during a Bloomberg interview that the ECB
does not plan to suspend coupons on AT1s and that banks are currently “very far” from breaching levels that would lead to coupons suspensions – reflecting the very strong fundamentals of the sector. This has already been confirmed by several banks.


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06 April 2020

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