Sentiment was particularly weak in March driven by fears around the banking sector in Europe and the US. Spreads on EUR investment grade (IG) widened by more than 20 bps to 170 bps after peaking at circa 200 bps during the month. Rates rallied on a combination of more dovish (at least as interpreted by the market) rhetoric from central banks as well as risk-off seen in markets. 10-year bund yields were 36 bps lower in March, which more than offset the impact of wider spreads as EUR IG corporates were +1% total return over the month. With concerns around the banking sector, financials underperformed materially, as spreads on EUR IG financials widened by 36 bps (non-financials +11 bps).
The fund’s NAV during the quarter (Z class, EUR) was roughly stable. Performance has been driven by spread widening partly offset by the decline in interest rates. Moreover, the fund’s performance was impacted by (1) the underperformance of financials versus corporates over the month by around 25 bps in spread terms (2) the underperformance of subordinated debt with spreads on euro IG Tier 2s and EUR Additional Tier 1s (AT1s) materially wider in March. Over the month, negative contributors to performance were mainly AT1 contingent convertibles (CoCos), that have been disproportionately impacted by the write-down of Credit Suisse (CS) AT1s, as well as generic concerns around the health of the banking sector.
Supply over the month was limited to a few senior deals in early March with circa EUR 2 billion of green and sustainability bonds from financials issued. Low supply was driven by weak market sentiment and dislocated markets towards the end of the month. The fund had no exposure to CS (never had any exposure) and is focused on high quality issuers in the European financial sector. Exposure to AT1 CoCos is 9.1% as of end March 2023, 9.5% as of Feb 2023 given the market moves. While these have been impacted by the wider sell-off, the majority is in BBVA’s green AT1 CoCos – an issuer that remained profitable during the Global Financial Crisis (GFC), eurozone (EZ) crisis and Covid-19. The rest of the portfolio is mainly Tier 2s (mandatory or cumulative coupons, no write-down trigger) or senior bonds of banks and insurers. As of the end of March, the fund has 26% exposure to bank Tier 2s, 23% to insurance Tier 2s and 37% to senior bonds from banks, on top of the 9% exposure to AT1 CoCos from banks (rest of ~5% of cash and FX forwards). Finally, the fund remains conservatively positioned, with more than 80% allocated to AA- and A-rated issuers – largely national champions and global banks in core European countries.
The underperformance of financials has mainly been driven by concerns around the sector following the failure of Silicon Valley Bank (SVB) and the write-down of CS’ AT1 CoCos and its acquisition by UBS. The SVB collapse and issues related to unrealised losses on banks’ securities portfolios in the US do not impact European banks, in our opinion. In Europe, banks’ liquid assets are mainly held as cash at the central bank (overnight) and holdings of longer-dated bonds are typically hedged using swaps. Moreover, European banks’ deposit bases are typically very granular and sticky with a material quantum of insured deposits from households. One of the key drivers of the issues in the US was the lack of strict regulation for non-systemic banks, as SVB was not subject to stress tests, liquidity requirements and had minimal capital requirements. Banks with a similar size (and even smaller) in Europe are subject to very strict regulation – similar to the large global systemic banks.
The acquisition of CS by UBS and write-down of CS’ AT1 CoCos is also an idiosyncratic event with no read-across for issuers or other AT1 CoCos held in the fund, in our view. The ability of the Swiss regulator to impose the full write-down of CS’ AT1s without imposing a wipe-out of equity was due to the specificities of the wording of Swiss AT1s and of Swiss regulation/legislation. Regulators in the EU and UK quickly reacted to the event by clearly stating that creditor hierarchy will be respected, which is required by law in the EU for example. Therefore, fundamentally nothing has changed for the AT1s held in the fund (no exposure to Swiss banks’ AT1s). At the margin, the acquisition of CS by UBS is positive for the rest of the sector as it removes some financial stability risks.
We remain positive on the sector, as European banks have strong capital ratios, robust liquidity positions and earnings will likely continue to benefit from higher rates. Upcoming Q1 results that will start to be released from mid-April onwards should be supportive – confirming the fundamentals of the sector. With a yield (to next call) of around 5.5% and an average spread (G-spread) of circa 300 bps on the fund (compared to 4.2% / circa 170 bps for the EUR IG corporate market), we see this as an opportunity to capture high income with upside potential from tightening spreads. This is despite the high-quality bias of the fund (average bond rating of BBB+ / average issuer rating of A) and lower duration compared to EUR IG corporates (4.0 versus 4.5).
Project Corner : Banco Santander
- Project type: Offshore wind farms
- Location: Massachusetts coast, US
- Project owner: Copenhagen Infrastructure Partners, Iberdrola
- Total investment: USD 2.5 billion (Santander’s share not disclosed)
- Electricity generation capacity: 800MW per annum
- Avoided CO2 emission: estimated 1.68 million tonnes per annum
- The first large-scale offshore wind farm in the US
- Electricity provided to 400,000 households with estimated USD 3.7 billion savings over 20 years of operations