Monthly comment
November was a very strong month for risk assets in general, following some positive macroeconomic data. We seem to be in the gradual disinflation scenario combined with a soft landing. This was taken positively by global markets and also meant that spreads on our securities had tightened. However, it is important to note that spreads on subordinated debt of financials remain wider than historical levels, and as such we believe that when the spreads tighten, there will be a combination of high income and capital appreciation.
Valuations and Fundamentals
We have come to the end of Q3 earnings season while results are very strong and resilient, especially from credit perspective. Financials continue to benefit from the higher interest rate environment, as this has resulted in higher net interest income. Subordinated debt spread of financials tightened during the month, which was in line with our expectation of repricing. As such, subordinated debt of financials remains extremely attractive, especially on a relative basis. For instance, spreads on subordinated debt are still significantly wider than high-yield bonds. Most of the debt securities we own are issued by Investment Grade companies, and in the case of a recession these credits should be significantly more resilient as demonstrated in the past. Given the attractive valuations and potential room for spread tightening of our securities, our strategy is positioned to seek higher yields and price appreciation.
Subordinated Debt
Technicals on subordinated debt of financials, notably for Additional Tier 1 bond (AT1) Contingent Convertibles (CoCos), have been extremely positive in November. Within AT1s, we saw 9 new issues, raising nearly USD 10 billion. The AT1 market is definitely alive and kicking, with demand for these new issues a staggering USD 75 billion, that is approximately 36% of the current market size. This really makes us believe that prices have a lot more room to keep going up. On top of that, we also saw other positive drivers, such as Banco Santander calling the AT1s they had not called in summer. It means that all the AT1s of national champions with a call date in 2023, got called. This is very much in line with what we have seen historically. Despite this, the extension risk (or non-call risk) remains largely overstated, while the AT1 market is still pricing in a bearish scenario where more than 55% of the AT1s are not expected to be called. We also see this extension risk largely overstated within other parts of the subordinated debt market, such as Restricted Tier 1s (RT1s), corporate hybrids and callable Tier 2s. 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 reverse is true when markets are stronger, and as such we expect to see further strong recovery. We believe this should benefit the fund going forward on top of the high income we are capturing.
