Outlook 2021: Subordinated Debt – A Credit Sweet Spot

Several areas of the subordinated debt market look attractive heading into 2021, both from an income and upside potential perspective.

We are constructive on the subordinated debt of high-quality financial issuers heading into 2021, supported by the prospect of a cyclical recovery, strong vaccine candidates, receding tail risks on the geopolitical front and central banks remaining accommodative. In our view, valuations continue to look attractive in a record low interest rate environment, and we believe subordinated debt offers value for investors that need to capture income but are unwilling to compromise on credit or interest rate risk. Our focus remains on high-quality issuers given remaining uncertainty around the long-term impact of Covid-19 and remaining geopolitical risks. Overall, for investors looking to capture a high income from strong issuers, we think subordinated bonds are a sweet spot in the credit market, for reasons explained below.

Fundamentals remain rock solid, a rise in non-performing loans (NPLs) is manageable

From a credit perspective, European banks have outperformed expectations and are entering 2021 in a position of strength. Capital has been the big beat, with an aggregate common equity tier one (CET1) ratio of 15.0% at the end of the first half of 2020, near all-time highs. Excess capital has increased significantly, now standing well above EUR 500 billion for the sector. Asset quality trends have also surprised to the upside, with NPLs only modestly rising by 20 bps to 2.9% year-to-date. While cost of risk has been elevated, pre-provision profits have been more than sufficient to absorb loan loss provisions (LLPs).

NPLs are expected to rise during the second half of 2021 as government measures aimed at providing liquidity to corporates (government guaranteed loans) and replacing income for individuals ease off. Despite a potential future rise in NPLs, we do not see this as a material risk for bondholders – especially with new accounting rules in place (IFRS9) forcing banks to take a forward-looking approach toward LLPs – ie making provisions based on macroeconomic assumptions even before NPLs arise. This means that a rise in future NPLs is already accounted for in 2020 LLPs set aside by banks. This is reflected in bank outlooks for LLPs, which are expected to decline significantly in 2021 compared to 2020 levels. As an example, HSBC has guided to the lower end of its USD 8-13 billion guidance for 2020, while consensus estimates for 2021 suggest USD 5 billion, close to half.

Moreover, even an unexpected surge in NPLs would be mitigated by various lines of defence and bondholders are well protected. In the example of Barclays below, we illustrate the protection that bondholders benefit from to show that even if NPLs were to increase by two or three times in 2021, this would remain an equity story and not a credit story.

Attractive valuations and high income

In our view, valuations remain highly attractive in the subordinated debt of high-quality financial issuers, particularly given the lower for longer environment for rates where senior debt valuations have been crushed by the European Central Bank (ECB). Investors have an opportunity to capture spreads above 400 bps (using AT1s as a proxy) or yields around 4%, compared to 0.2% yields on EUR investment grade (IG) credit, for example. Spread levels captured remain wide of post global financial crisis (GFC) levels of circa 270 bps, implying more than 130 bps of potential further tightening to reach levels that would still offer around three times the spread on senior debt, and more than 10 times in yield terms.

Chart 1: Subordinated debt offers attractive valuations in a negative yield environment

Beyond capturing attractive income, we continue to see some price appreciation potential. Our preferred indicator, the percentage of the AT1 contingent convertible bond (CoCo) market priced to perpetuity, suggests a quarter of the market is still priced to non-call. This compares to historically 0-10% of bonds not being called (on a rolling 12-month basis); therefore extension risk remains mispriced, which creates opportunities as bonds re-price to call.

Chart 2: Percentage of AT1 CoCos priced to perpetuity

Areas of focus

Heading into 2021, we continue to favour attractive bonds within the capital structure of high-quality financial issuers. Beyond AT1 CoCos, there are several areas we view as attractive, both from an income and upside potential perspective.

We regard insurance RT1s as one of the sweet spots of the subordinated financials debt markets. RT1s offer similar spreads (circa 400 bps) and yields (circa 4%) to AT1 CoCos, but with a far more favourable structure for bondholders. The very limited coupon risk that occurs if insurers breach remote requirements, as well as no bail-in regimes, means that these should trade significantly tighter than AT1s. More limited risk levels are also reflected in ratings, which are BBB-/ BBB for RT1s compared to BB / BB+ for bank AT1s. Therefore, investors can capture attractive yields of investment grade (IG) rated bonds.

Legacy bonds from banks and insurers rallied in the second half 2020, as several issuers engaged in attractive tenders (offering 4-5 percentage points above market levels) and regulatory pressure continues to mount for issuers to take out bonds. We continue to see strong value in taking a pure bottom-up approach when selecting bonds. For example, the insurance legacy undated floating-rate notes (FRNs) continue to look attractive, in our view, with circa 5% average yields to call in December 2025 (end of the grandfathering period), higher than new-style AT1s or RT1s. We believe grandfathered AT1 CoCos also offer value. For example, Swiss low-trigger bonds (disqualified after the first call date) or AT1 CoCos ineligible under the Capital Requirements Directive and Regulation (CRR2) are disqualified after June 2025, with similar yields / spreads compared to fully eligible AT1 CoCos but with zero extension risk.