October was a better month for risk assets, notably subordinated debt which performed strongly. Softening gas and energy prices, coupled with the latest developments in the UK, as well as a more dovish tone by the European Central Bank (ECB) all helped the sentiment at the end of the month.
Valuations and fundamentals
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, as reflected by Q3 earnings. We have seen strong increases in net interest income (NII), due to higher rates, which outweighed the increase in provisions due to macro uncertainty. For instance, Barclays delivered a GBP 1.5 billion net profit (12.5% return on tangible equity) for the quarter as NII was up GBP 1.1 billion year-on-year (each 25 bps rise in rates has a GBP 0.2 billion positive impact on NII in year one, GBP 0.5 billion by year three), more than offsetting normalising revenues in the corporate and investment bank (CIB) and higher provisions for loan losses (reflects UK macro uncertainty). Capital remained strong as the bank’s common equity tier 1 (CET1) ratio was up on the quarter to 13.8% – roughly GBP 10 billion excess capital. The bank is expected to make close to GBP 10 billion of pre-provision profits in 2023, which compares to GBP 4.8 billion of loan loss provisions booked in 2020 during Covid-19 and GBP 7.4 billion at the peak of the global financial crisis (GFC). This means that even in a GFC-style scenario increased loan loss provisions should be covered by earnings only, leaving excess capital unscathed. As stated above valuations are getting very close to the wides of Covid, despite the strong credit fundamentals.
On top of that, we are capturing high income. As an example, BBVA 6.5% Perp currently has a yield to next call in 2026 of more than 11.0%. The yield to worst is around 10.0%. As we can see most of the subordinated debt is pricing extension risk (around 90%), 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.