Risk assets continued performing strongly in November, especially following the lower-than-expected US CPI, signalling the potential for the beginning of a Federal Reserve (Fed) pivot. Moreover, some relatively dovish comments following the European Central Bank (ECB) meeting also contributed to the positive sentiment. Subordinated debt prices benefited during the month.
Valuations and Fundamentals
Despite seeing the beginning of a recovery in prices, we believe valuations are attractive, as spreads have widened significantly year-to-date. This is despite the fact that credit fundamentals of financials remain strong. Non-performing loans (NPLs) for European and UK banks are currently at all time lows, and capital ratios remain close to all time highs for both banks and insurances. Moreover, higher interest rates mean higher net interest income (NII) for banks, which will translate into higher profitability and return on equity. This should outweigh any increase in NPLs resulting from the macroeconomic uncertainty. As an example, HSBC will earn USD 5 billion of extra NII for each 100 bps rise in rates. HSBC’s expected pre-provision profits are expected to be USD 31 billion in FY23 and USD 33 billion in FY24, which is roughly USD 15 billion more than in the past three years. Just to wipe out the extra annual profits you need a very weak scenario (Covid-19 loan loss provisions were USD 8.5 billion). Provisioning based on the group’s worst downside scenario would lead to an extra USD 6.6 billion of extra provisions. We believe this demonstrates that financials are well equipped to deal with any type of macro scenarios going forward.
We are capturing high income. As an example, Banco Santander 4.375% Perp currently has a yield to next call in 2026 of more than 9.5%. The yield to worst is also around 7.7%. We also observe that a large part of the subordinated debt market is pricing extension risk, in spite of the fact that additional tier 1 (AT1), restricted tier 1 (RT1) and corporate hybrids are perpetual bonds which have call dates and a strong track record to be called at first call date. During risk-off environments such as this year, 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 normalise, spreads of those bonds start to tighten, leading to a repricing to next call date and sequentially creating a double-positive effect on prices. As the large majority of our bonds are pricing the extension risk, we believe they should benefit going forward as valuations tighten. In the meantime, we are receiving considerably high income.