Monthly Archives: November 2018
Monthly Archives: November 2018
Someone earlier asked me a thought-provoking question on AT1 to me – why do they trade with such high yields given that the coupons are almost safe (and most likely be paid) and bonds may get called on first call date and the banks issuing them are so well known domestic names?
And I just did not know where to start and how best to put it across to that investor that the AT1 instrument is more like an equity instrument sold in a debt format and the investor has sold many options to the issuer. Many investors have bought this instrument for its relatively high yield and debt-type features and conveniently forgotten the equity type risks loaded in the same. But frankly, I think AT1 is more a hybrid instrument with significant awkward tail risks embedded in them.
Whilst coupons will most likely get paid for most issues unless mandatory deferral clauses come into play, purely from a structure perspective, they are discretionary payments (issuer has optional discretion not to pay) and are non-cumulative in nature.
As far as the call is concerned, it is most probably an economic decision based on where the bank can re-issue / refinance the same and to that extent, irrespective of the reset spread, it is entirely possible that issuer decides not to call as market conditions are not favorable. And yes the higher reset spread on older AT1s may yet prove to be decisive in the economic decision to call. However, the issuer may yet decide not to call the bonds and then subsequently suspend the coupon.
Will any of the current European banks dare do that anything like that? The answer is most likely a big “no” – as it will cut the issuer from future sub-debt issuance for an extended period of time.
Consider this scenario in the next 12 months – The issuer has already filled the AT1 quota, has a decent CET1 ratio (and is well in excess of requirements), is in a deleveraging mode, has plenty of funding options (and hence MREL/TLAC may not be an issue) but has very poor profitability due to business model, equity shareholders have taken a bucket load of pain & equity dividends are likely to be skipped and the issuer has to incur significant restructuring charges in one go to simplify the set up. Finally, the share price trades a huge discount to tangible discount value and market perception on the issuer about its turnaround prospects are poor.
In such a scenario, I believe that the issuer may yet consider the optional coupon suspension for the AT1 instruments to further preserve capital and/or appease equity shareholders (who may not be getting any dividends). And that is perfectly allowed by the terms and conditions of the instrument. I would assign a very small probability to that event but if it were to happen, it may turn out to be a giant one for the asset class.
And as far as the call is concerned, good luck to those investors hoping that issuers will make non-economic decisions.
AT1 – is this sub-debt with equity features or an equity-like instrument with loaded options? Or just an awkward one that satisfies no one…and hence I keep repeating the same thing – AT1 needs expert/specialist handling and an extreme form of “buyer beware”. Having said that, keeping the negative generalisation of the asset class to one side, there are enough upside opportunities in this space if (and that is a big if) proper single name selection and within that a deep dive issue level analysis is carried out.
PS – In my personal view, there are a couple of issuers that may yet fall into the situation I described above. As always, timing is everything in AT1 investing.
So, here we are. The UK government agrees a draft Brexit deal with the EU and yet markets fret about the uncertainty in terms of whether it will be approved and if a hard Brexit can be avoided. Without going into the consequences of the final outcome, the UK banks that are most exposed to the domestic economy are most vulnerable and that is seen in stock price reaction for the likes of Barclays, Lloyds and RBS.
In fact, RBS is down almost 10% on fears that the bank may face an uncertain future if there is a change in government. So clearly, there is significant uncertainty coming our way over the coming weeks and hence a very clouded negative outlook.
Whilst it is difficult at this stage to be very precise about the exact negative consequences of a hard Brexit and its impact on the banks, one could carry a stress test on the balance sheets and get an idea of how much capital erosion may happen.
The BOE is due to publish the 2018 annual stress test results on 5 Dec 2018 and that will give us more clarity on the state of capital at the large UK banks. However, last year’s annual stress test results published in Nov 2017 do give us enough insight about the capital situation.
In the 2017 stress tests, the following parameters were used to assess the deterioration in capital levels at the various institutions and if any capital actions were required:
Under the above scenario (very stringent in my view), in last year’s stress test, all of the banks came out well with none requiring any additional capital actions. In the test, banks incur losses of around £50 billion in the first two years of the stress. The stress reduces the aggregate CET1 capital ratio from 13.4% at the end of 2016 to a low point of 8.3% in 2018. The aggregate Tier 1 leverage ratio falls by 1.1 percentage points, from 5.4% at the end of 2016 to a low point of 4.3% in 2018.
Barclays and RBS had the biggest drops in core capital and did not meet the CET1 capital ratio “systemic reference point” using the end of 2016. But as the report mentioned, since then both banks have increased their CET1 capital ratios and hence no action was required. Just as a point of reference, Barclays CET1 ratio has increased from 12.4% at end 2016 to 13.2% at end Q3 2018 and RBS has increased its CET1 ratio from 13.4% at end 2016 to 16.7% at end Q3 2018. Using similar parameters for the stress test, it seems that overall losses are still an earnings event and not a solvency event for any of the large banks.
Without going into the details, RBS seems to be in the best position to handle large losses from a severe economic shock given its starting CET1 ratio followed by Lloyds and Barclays. HSBC and Standard Chartered Bank seem to fare reasonably well but that is a function of their business model (and more reliant on what happens in EM, especially in Asia)
To me, the real question is what happens if a triple combo tail risk event were to happen in one go (hard Brexit, sharp slowdown in global growth and a full-blown EZ/EU crisis) leading to a dramatic drop in revenues and significant loan losses to be incurred over a very short period of time. In such a shock scenario, the CET1 ratios of the banks come under pressure with the likes of Barclays, Lloyds and Standard Chartered not faring that well. Even in that scenario it seems that minimum solvency ratios are not breached but certain regulator-imposed ratios (Pillar 2 requirements, MDA for AT1 coupons) may yet be breached.
Clearly equity investors are going to nervous owning UK banks (especially those who domestically focused and/or have government ownership) primarily due to earnings at risk and we could yet see further drops in stock price.
It is in AT1 land (in particular the GBP issues) that I sense the biggest risk to price drop given the limited investor base and even more limited liquidity. If anything, the USD AT1 issued by Lloyds and HSBC seem the most defensive to own given the back-ends whilst the ones issued by Barclays, RBS and Standard Chartered seem the most exposed for varied reasons. Having said that, if the USD AT1s issued by Barclays and RBS were to significantly drop in price and if yields to perpetuity were to reach 8% and above, they would be very attractive to own/add, more so relative to owning the respective bank’s equity.
In LT2 and HoldCo Senior, current valuations seem just about fair for the risks outlined but can they get cheaper and more attractive over time? The answer is a resounding “Yes”.
Hence my title that owning sub-debt in the UK banks is like owning BBB- negative outlook paper and the transition from one set of investors to another may yet turn out to be painful, to say the least.
Standard Chartered (STANLN) and Banco Santander (SANTAN) have similar business models in retail/commercial banking especially in emerging markets – but underneath they display very different characteristics. To some extent, both have diversified geographical exposures with a strong domestic franchise. The key difference seems to the region of focus.
STANLN is predominantly focused on fast-growing markets in Asia, Middle East and Africa which expose the bank to the cyclical fortunes of the two major Asian economies – China and India. SANTAN is focused more in Western Europe especially in Spain, UK & Portugal and in the US & Brazil, which expose the bank to the tail risks in Europe and LATAM. So whilst STANLN is a thoroughbred in EM land, SANTAN is probably the PAN European champion retail bank that others are aspiring to be.
Just going through the numbers it is clear that SANTAN is a much bigger bank than STANLN in almost every conceivable way – total assets, total loans, revenues, net income, shareholder equity and ultimately market capitalisation (SANTAN’s market cap is EUR 69 billion versus STANLN’s GBP 20 billion). SANTAN also delivers a higher ROTE than STANLN for the time being and is able to use its global reach to much better effect and by keeping both operating costs and credit costs low.
It seems that SANTAN’s better earnings track record is preferred by equity investors as seen in the year-to-date share price performance, which has been slightly better than STANLN. And on one metric SANTAN comfortably beats STANLN and that is on Price/TNAV. SANTAN is one of the few European banks whose P/TNAV is close to 1.0 times. STANLN’s P/TNAV trades around 0.45 times, reflecting investor pessimism over growth and business restructuring. SANTAN with its acquisition history is able to project its future growth prospects much better than STANLN.
The question for equity investors then boils down to two things:
But in credit land what I see is the exact opposite as STANLN debt instruments trade much better than SANTAN in terms of spreads and more importantly in terms of perception of credit risks.
Historically, both in AT1 and LT2, it seems that STANLN trades tighter in spread than SANTAN and this may be due to:
Whilst the above factors may be valid, in my opinion, I see a convergence in credit spreads between the two names as the market factors in a higher credit risk premium for EM risk especially if there is a significant slowdown in China. It remains to be seen how long that would take though to materialise.