Monthly comment
Volatility on interest rates remained elevated during October. However, the market is starting to believe that we might have reached peak interest rates. Inflation remains too high but has been easing. Spreads on our securities widened during the month, despite the extremely strong credit fundamentals of our companies.
Valuations and Fundamentals
Q3 results have begun to emerge and we have been seeing very strong numbers, especially from a credit standpoint. For instance, Banco Santander continued benefiting from higher net interest income which enabled it to generate 15.5% return on tangible equity. There have been concerns that some of the UK names might have reached peak Net Interest Margin (NIM) profitability. However, this is really an equity story and, in our view, from a credit standpoint everything is on track. For instance, Barclays generated earnings of GBP 1.3 billion in Q3 and managed to continue increasing its capital. Despite all this, spreads on our securities continued widening during the month and remain at very wide levels historically. We believe this creates significant opportunities and will reverse as credit fundamentals should drive valuations going forward. Moreover, spreads on subordinated debt remain significantly wider than high yield. That is despite the fact that most of the issuers we own are investment grade companies and, going into a recession, these credits should be significantly more resilient, as demonstrated in the past. As such, in our view, valuations are attractive and have significant room to tighten ie, for the prices of our securities to go up.
Subordinated Debt
We continued seeing positive news within subordinated debt during the month. For instance, UBS called one of their Additional Tier 1 (AT1) bonds, despite the economics which were not favourable for a call. This was a strong message from an issuer and is in line with what we have seen in the past from core issuers. This means that more than 90% of AT1s have been called this year. This is similar to what we have seen historically. Despite that, extension (or non-call) risk remains largely overstated; the AT1 market is still pricing more than 75% of the AT1s as if they will not be called. Within other parts of the subordinated debt market, such as Restricted Tier 1s (RT1s), corporate hybrids and callable Tier 2s, we also see this extension risk as being largely overstated. 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.
