Macro Backdrop
May was a positive month for risk-based assets in general as there has been a sustained de-escalation of trade war-related issues. The tariff “pause” between the US and China contributed to the positive sentiment on markets. Moreover, the potential for 50% tariffs on the EU was quickly suspended, while good ‘hard’ macroeconomic data also helped. All of this meant that that risk assets performed strongly in May and credit spreads tightened. For instance, spreads within Additional Tier 1 (AT1) Contingent Convertible bonds (CoCos) tightened from 360 basis points (bps) to 312 bps. Since 9 April, the different decisions by the Trump administration have been taken positively by the markets, as the worst-case scenario seems to be excluded. However, uncertainty remains and it is difficult to see what impact it will have on the macroeconomic data. At the same time, credit spreads are at very tight historical levels reflecting our view that a lot of positive news is already priced in. As such, we believe some caution is warranted.
Valuations and Fundamentals
As stated above, spreads within the credit market have tightened during the month. Extension risk, which looks at the percentage of AT1 CoCos priced to perpetuity or call, went down during the month and is currently around 20%. When market conditions are poor it tends to peak at 100% and when market conditions are very strong, this percentage tends to approach 0%, indicating that valuations are very tight. During the market sell-off in April, we used this as an opportunity to increase the fund’s allocation to AT1 CoCos by 10% to 25%, as spreads widened and extension risk went up. However, from a risk-return perspective, we believe there remains more value in Tier 2 and senior bonds from financials. Earlier in the year, this approach helped us since we had a significantly smaller drawdown than AT1 CoCos. The tightest historical levels on AT1 CoCos were on 18 February. From that date until 9 April (lowest point of the selloff), our fund was down -1.06% versus -4.22% for USD AT1 CoCos, as measured by the Bloomberg Contingent Capital USD Total Return Index (Value Unhedged USD)
Subordinated Debt
With markets continuing their normalisation, we saw a number of new issues coming to the market. For instance, there were nine new AT1 issues in May representing approximately USD 9 billion. We saw demand of close to USD 50 billion for those new deals. As such market technicals seem to be strong. Most of these new issues performed well, since as stated above, spreads have been tightening during the month.
