May was volatile, although sentiment started turning slightly more positive at the end of the month. Spreads on subordinated debt of financials remain extremely wide. A number of our holdings have spreads well above 450 bps. Concerns regarding inflation remain and central banks are continuing along a gradual path of tightening. However, we are currently generating significantly high income through the coupons we are receiving. As such, we believe we are well positioned to benefit within the next six – 12 months. We are currently experiencing one of the largest drawdowns within the last 10 years. In previous periods of drawdowns, we have seen our securities recover within the next six – 12 months, through a combination of income and price appreciation.

We have reached the end of Q1 earnings and credit fundamentals remain very strong with capital ratios close to the highs. Excess capital remains at very high levels. For instance, BBVA has excess capital of more than 4.5%, which represents around EUR 12 billion in monetary terms. Most of the national champions have similar numbers. As such, we believe we have strong visibility on the income our securities are generating. With yields at very high levels, income will be a strong driver of performance going forward.

Another positive indicator in terms of valuations is the fact more than 50% of Additional Tier 1 (AT1) securities are priced to perpetuity. AT1 securities are perpetual bonds which have call dates. During positive market periods, most of the AT1 securities are priced to the next call date. However, during risk-off environments such as this year, a large number of those securities reprice to perpetuity. This creates a double-whammy effect on prices. The fact more than 50% of AT1 securities are priced to perpetuity suggests valuations are becoming attractive. Moreover, this repricing has sometimes been done indiscriminately without looking at certain characteristics. For instance, Credit Suisse has some AT1 securities which will lose all of their capital characteristics on the first call date. As such, it is extremely likely that Credit Suisse will call those securities at their call date in 2024, irrespective of market conditions. Despite that, those securities are pricing some extension. We have been seeing similar extension risk being priced in within corporate hybrids, where the likelihood of non-calls is extremely low, especially as in a large number of cases the corporate hybrids lose their equity content on the first call date, ie the issuers often have no incentive to keep them outstanding irrespective of market conditions. Therefore, our securities should benefit strongly from a potential recovery in the markets, in our view.

Finally, our fund has demonstrated that it behaves well in a rising interest rate environment, as we have a large number of fixed-to-floaters and floating rate notes, and due to the fact financials benefit from rising interest rates. Despite the market weakness since the beginning of the year, the high income we are receiving combined with attractive valuations creates opportunities and we believe we should benefit from that, especially as credit fundamentals remain very strong.

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