Market Backdrop
March was all about banks, following the events regarding US regional banks and Crédit Suisse. We believe that these were two very different situations. Moreover, these were two idiosyncratic situations in our view, and we do not believe there should be any read across to European banks and financials. Due to the structure of the Crédit Suisse takeover, it created price volatility within Additional Tier 1 (AT1) contingent convertibles (CoCos), which initially fell significantly. However, we have started seeing some recovery, notably due to the fact European and UK regulators have commented that AT1 bondholders are always senior to equity holders. In terms of the rest of the macroeconomic situation, we have seen government bond rates fall significantly, notably due to the expectation that central banks will potentially be more accommodative going forward.
Valuations and Fundamentals
Spreads widened significantly during the month, and this partially explains the negative performance we observed. It is important to note that spreads on subordinated debt of financials have significantly widened, notably for AT1s. On other parts of the capital structure, we saw a small widening. For instance, Lower Tier 2’s widened by 40 bps during the month. We believe Credit Suisse was an idiosyncratic story. It was also undergoing a restructuring which is not the case for other European or UK banks. When we review our holdings and other banks we cannot find another large European bank that is even remotely in the same situation as CS. The risk of write-down on European banks’ AT1 CoCos has not changed, and we believe the possibility remains extremely remote given the strength of the European banking sector that is very strongly capitalized, with strong liquidity positions and tightly regulated. For those banks, we have also observed a trend of increasing net interest income due to higher interest rates, which has resulted in strong profitability. From a portfolio standpoint, we are receiving strong income, and as such that should be a factor that helps us going forward.
Subordinated Debt
We are capturing high income, with many securities having yields well into double digits. Spreads on subordinated debt are extremely wide and as such we believe the fund should benefit from price recovery going forward. We also observe that close to all of the subordinated debt market is still pricing extension risk, referring to the risk that borrowers will not call bonds due to market conditions, in spite of the fact that while AT1s, and Restricted Tier 1s (RT1) and corporate hybrids are perpetual bonds, they have call dates and a strong track record to be called at first call date. We therefore believe that the extension risk is still 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 opposite is true too, ie when markets begin to normalize, spreads of those bonds start to tighten, leading to a repricing to next call date and sequentially creating a double-positive effect on prices. In the meantime, we are capturing high income.
