Macro Backdrop
Sentiment was weaker in March, as the trade war continued to be in focus with markets awaiting the 2 April tariff announcements. Equity markets, particularly in the US, were significantly affected by the potential tariffs. This was less the case for the bond market, although credit spreads did widen during the month. Moreover, European government bond rates went up significantly on the back of potential for larger fiscal stimulus, especially in Germany. This was not the case for US interest rates, leading to the underperformance of Eurodenominated in March. Spreads within Additional Tier 1 (AT1) Contingent Convertible bonds (CoCos) widened to 314 basis points (bps), which remained close to the historical tights.
Valuations and Fundamentals
As stated above, spreads within credit markets have widened slightly, but remain at the tighter end of historical values. While this could be justified by fundamentals, we know credit markets tend to be cyclical. As such, we believe some caution is warranted. Moreover, sentiment has been slightly weaker due to geopolitical tensions and lower US equities. Additionally, extension risk, which looks at the percentage of AT1 CoCos priced to perpetuity or call, remains below 15%.
When market conditions are poor it tends to peak at 100%, and when market conditions are very strong, like currently, this percentage tends to approach 0%, indicating that valuations are at their tightest. As such, from a risk-return perspective, we believe there is currently more value in Tier 2 and senior bonds from financials. The last set of Q4 earnings were strong, coming above consensus expectations on average – while credit metrics remain robust. The sector’s fundamentals are expected to remain very strong, with an anticipated circa 11% return on equity in 2025 and 2026. On the insurance side, Q4 earnings were also strong and solvency generally remains above 200%.
Subordinated debt
There were three new AT1 issues in March. Those represented approximately EUR 2 billion and we saw demand of approximately EUR 14 billion. As such, one could believe that market technicals remain very strong. However, it is important to note that a number of the new issues we have seen in 2025 have actually underperformed significantly in the secondary market. As an example, UniCredit issued a 5.625% EUR AT1 in February at 100%, which is currently trading at 94%. Most of the current new issues have come at relatively tight levels, which also means the resets are at tight levels. Therefore, markets may be underestimating extension risk. Moreover, we know the low-reset bonds (such as the new issues) tend to be more volatile, and as such, we do not think they are attractive at current valuations.
