The tone in subordinated financial markets was softer in February, reversing the strong sentiment in January. This was mainly driven by volatility from the Coronavirus outbreak and potential repercussions on the economy, with the EUR AT1 CoCo index down close to 2.6%. Spreads have widened by c100bps to c440bps in EUR and by c90bps to c380bps in USD, as prices have declined, partially offset by the move lower in rates (10-year German government bond close to 20bps lower and 10-year US government bond close to 35bps lower on the month). Nevertheless, Legacy bonds continue to perform well despite the weaker markets given the significant upside potential. Moreover, the most recent new issues that came at very tight levels (and that we have avoided) underperformed in the sell-off given fears around extension risk. For example, BNP issued an AT1 CoCo in mid-February Perpetual callable in 10 years with a very tight spread of 294bps, and dropped below 95% in the end of February given the unfavorable bond structure and longer duration. Spreads on subordinated financials debt (c440bps on AT1 CoCos for example) remains highly attractive and we continue to see upside on prices as well as continued high return contributions from income collected.

 

Bank stocks have been heavily impacted by the recent sell-off due to the coronavirus, -16.4% total return year-to-date (EUR Bank stocks). As expected, subordinated debt has been more resilient to the sell-off, up 0.4% YTD (EUR AT1 CoCos) – significant outperformance, reflecting the very strong fundamentals of issuers (for example HSBC’s excess capital increased to $29bn in 4Q19 despite pressure on earnings).

 

EUR subordinated debt has underperformed USD subordinated debt in the recent sell-off, reflected by EUR AT1 CoCos up 0.4% YTD vs. USD AT1 CoCos up 0.8% YTD. The key driver of the higher volatility of EUR AT1 CoCos is the higher proportion of peripheral names (for example Italy is now c20% of the index, Spain 28%) while there only very limited peripheral issuance in the USD index (Italy c2%, Spain c2%). Taking as an example HSBC’s USD AT1 CoCos are significantly less volatile than UniCredit’s AT1 CoCos – and less impacted by market sentiment.

 

Since the start of the week/month of March, we have been seen some price recovery between 0.75% and 1% for the funds

 

Overall – we continue to be well positioned – with no exposure to Italian banks (Coronavirus cases have exploded in Italy which could have economic repercussions), and with strong upside on legacy bonds. 8% return guidance for the EUR fund and 9% for the USD fund remains unchanged.

 

EUR Bank Stocks underperform AT1 CoCos

 

EUR AT1 CoCos more volatile than USD AT1 CoCos

 

UniCredit’s AT1 CoCos are significantly more volatile than HSBC’s AT1 CoCos

 

Legacy bonds have been resilient in the sell-off vs. AT1 CoCos

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