Monthly Archives: November 2018
Monthly Archives: November 2018
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For all the attention on DB & its inability to generate decent ROE and the consequent equity underperformance this year, BNP is another large cap national champion bank that seems to have lost its way with its equity which is down almost 35% YTD. Looking through the reported Q3 figures, although not that obvious at first glance, equity investors seem to have focussed on some disturbing underlying trends.
To start with, the bank, like its peers, is struggling to generate decent revenue growth in its corporate and investment bank, especially in its FICC business. On top of that, the bank’s cost-to-income ratio is in the 70% area. Loan losses have come down but that is due to benign economic conditions in Europe. Yes, it reports an acceptable 9% to 10% ROE for now but earnings are now exposed to multiple headwinds.
Asset quality and risk management used to be strong points – but with a reasonably large stock of NPLs and presence in Italy, Turkey and other Emerging Markets as well as exposure in personal financial services, future credit-related costs may yet go up. And additional provisioning may yet be needed at a time of decreased revenues and a stagnant cost base.
Overall funding metrics seem fine with a loan-to-deposit ratio around 94% and a highly diversified funding base. But that cannot mask the bank’s reliance on wholesale funding (?) given its large balance sheet size. As a large and frequent issuer of debt securities, the bank has very good access to capital markets and is able to issue debt at satisfactory spread levels.
Capital is where I find that the bank has really not kept pace with global peers. Yes, CET1 ratio is a decent 11.7% and leverage ratio at 4% (and it was at 4.6% at end of 2017) but in the event of a large tail risk event, these ratios drop sharply. In the recently concluded EBA stress test, the bank’s CET1 ratio dropped to 8.64% in a hypothetical adverse scenario. The bank seems to have levered up its balance sheet in recent periods, especially in the investment bank.
Given the leverage situation and potential for headline risks stemming from a presence in Italy and Mediterranean countries, in my personal view, the bank’s AT1 securities and LT2 debt seem to trade tight. I think that this is a function of the bank’s French domicile and perceived strong risk management strengths.
Relative to equity, I wonder if AT1 holders have more confidence in the bank’s overall business strategy, past track record and current fundamentals despite the recent underlying trends and issues.
Only time will tell if this comfort factor of credit investors is justified.
It has clearly been a tough 2018 for many asset classes and, within that, AT1 has not been spared. The asset class saw its first annual loss with most of the widely followed benchmark indices down 3% to 5%. The asset class has been hit by risk aversion, tail risk events and investor apathy.
However, it seems to me that within the credit world, AT1 has been hit hard more due to liquidity and momentum factors. It is becoming increasingly technical in terms of who holds it and driven by headline risk. Everything else in terms of valuation doesn’t seem to matter. My observations on a handful of AT1s reflect that it trades in a very tight space and ignores any concept of fundamental valuation. More so on a relative valuation basis either to equity and/or LT2 or Non-Preferred Senior.
Looking at the performance of AT1s issued by the European banks over the last 6 months, it is clear that much of the larger “underperformance” in certain names has been driven by idiosyncratic stories/themes – ISPIM and UCGIM impacted by Italian politics, BBVA by Turkey exposure, Danske Bank due to on-going operational risk related issues and 2018 vintage issues due to re-pricing of call risk.
A full-blown CDO type balance sheet analysis on some of the banks in my universe indicate significant relative value opportunities in both directions (long equity vs short AT1 in some cases and long AT1 and short AT1 in others) but finding the right notional amounts to use and the underlying liquidity to actually put it to work is even more challenging. Fundamentals are important, for sure, but it seems that market technicals seem to matter equally.
In nearly all of the above names, the underperformance of equity to AT1 has been even more dramatic. Two observations – RV across issuers and/or capital structure has been the only effective way to manage the portfolio risks and the importance of deep-dive analysis in selecting single name exposure within the AT1 asset class.
Now comes the more difficult part – which single name exposures to own? Without going to specific names or issues at this stage, we could yet set up criteria to come up with a shortlist of names to own:
There are a number of large cap European banks that would meet most of the above criteria (if not all the criteria). I don’t want to give away those names as yet as I am sure you will find the exercise much more interesting.
Bye Bye – I believe we may yet see more price weakness as more investors figure out that this asset class is not for them. And if equities keep going lower, purely from a sentiment perspective, AT1s will get dragged lower. So maybe it is bye bye time for some tourist investors.
Buy – Having said that there are a number of issues that look attractive to own for long-term investors. Next comes the question of liquidity, as to who would be the marginal buyer of these AT1s in size and what is the clearing level for that. I believe that AT1s yielding 8% (and above) on a yield to call basis and 7% to 8% on a yield to perpetuity basis should find some decent interest.
And when it gets there, I believe specialist bank capital funds, distressed debt shops and private equity firms will want to own this – but as a price taker.
The asset class needs a certain type of deep pocket investor with locked in capital and one who is prepared to do the necessary deep-dive work both at an issuer level and at an issue level. And be able to slice and dice the balance sheet to estimate asset recovery values and its impact on capital structure. Finally, of course, have the ability to stomach the volatility as the markets price in one tail risk event to another. And don’t forget a specialist who understands the instrument, the issuer and the macro tail risks.