I can empathise with those who think that investing European bank capital is not that interesting given the plethora of negative news and it is the usual story of missed opportunities, sovereign bank nexus and difficulty in estimating recurrent earnings etc. Plus, the ongoing issues around business model, KYC issues and reliance on wholesale funding. So one could easily conclude that there is hardly anything to get interested in.
However, there are a quite number of interesting idiosyncratic stories to focus on and potential trade ideas to consider.
Low global growth prospects in and Brexit uncertainty means that earnings estimates may yet be a bit high for a number of large-cap European banks. And some banks have already announced further cost costs to improve returns. Yes, on the margins the cost cuts help improve overall returns but the underlying issue is of revenue growth and the need to transform the business model (in the era of technology-driven disruption). And in that context, the European IBs have significant work to do in terms of strategy and business rationalisation. There is a significant relative value proposition in the AT1s issued by the UK and Swiss banks with large investment banking operations.
Amongst the periphery banks, Santander has always enjoyed a better investor reception due to its ability to deliver earnings. But, this is a bank with significant operations in Brazil, UK and consumer finance and one wonders if the bank’s CET1 ratio is on the lighter side relative to its peers with a similar business model.
It’s very interesting to note the bank’s CEO comment that they think the current capital rules are too tough and that investors and analysts should lobby the ECB to loosen it. I would argue that the bank’s AT1s are much more attractive than its equity purely from a valuation perspective.
Austrian and Belgian banks have benefitted from their Core EZ domicile but they do have significant CEE exposures. Amongst the Austrian banks, Raiffessein Bank International’s AT1s have been impacted largely due to its Russian exposure and money laundering issues and to some extent reflect the uncertainty around those two issues. However, the AT1s issued by Erste Bank and KBC don’t seem to have been impacted that much despite both banks having large CEE operations. And more so on the low coupon, low reset AT1s.
Without a doubt, an Italian recession or political crisis will have a significant impact on the Italian banks given the amount of government debt they hold and the ongoing reliance on ECB for funding. And these issues are well documented and no real surprise and hence no point in pretending otherwise.
It seems to me that credit market (especially subordinated debt) investors seem to perceive that the French banks are in a much better position. I would argue that perception is misplaced to some extent and that they carry significantly higher tail risks in the balance sheets.
All the three major French banks (BNP, SOCGEN and Credit Agricole) have significant issues to contend with – slowing domestic and Euro Zone growth, significant cross-border exposure especially to periphery and EM,subscale investment banking business with high operating costs and more importantly, running leveraged balance sheets.
First it was Danske, then came Swedbank and now Nordea and suddenly the money laundering scandal issue is starting to look systematic in the Scandinavian banking system. All three banks are very well capitalised and hence in a good position to absorb any large settlement / remedial costs, but the impact on earnings is likely to be substantial and the uncertainty means modelling any earnings estimates likely to be very difficult.
Add to this the pressure on interest margins (given the accommodative monetary policy in Europe) and ongoing disintermediation by new FinTech players, the ability of the banks to generate decent ROE is questionable.
AT1s issued by Scandinavian banks trade very tight on spread basis given their flight to quality status in the past and high reported regulatory capital ratios. The risk premium demanded by investors to hold the AT1s issued by the Scandinavian banks seems low and I would expect re-pricing.
An FT article is saying that Unicredit is preparing a rival bid for Commerzbank if the DB merger does not materialise. Potentially this makes more sense given Unicredito is already in the German market through HVB and combining HVB with Commerzbank will create a national champion.
But the real question is – will the German politics allow the combined bank to be owned by an Italian bank? If yes, it would be a big thing for cross border deals in EZ and a proper banking/capital market union beckons. And if no, then back to square one.
As the article says, other banks will be interested (BNP/SANTAN) and to that extent, Commerzbank equity has more upside. But for credit investors, it is a bit more nuanced. If Commerzbank does end up within a Unicredit set up, potentially a higher risk premium may be demanded by investors.
Depending on how it is structured and how much Unicredit end up spending, their capital ratios may come under pressure given the bank’s presence in CEE and Turkey and, of course, in Italy.
Bank capital instruments (AT1 in particular) are high yielding but also come with significant volatility in form of tail risks. And every bond, every issuer has something unique that distinguishes it from others and hence needs plenty of deep-dive work. In addition, unlike corporate entities, cash flow modelling does not work as investing in financials requires a good understanding of macroeconomic events and tail risks.
That is what makes bank capital investing so interesting. There is never a dull moment.
First it was the PBOC, then came the ECB and now the Fed. Investors are now starting to pencil in the likely new era of “EGG ME” or Extraordinary Globally Guaranteed Monetary Easing in perpetuity. And in this “EGG ME” background it is becoming difficult to get bullish on bank equity in any part of the developed world.
I would argue that in certain parts of the world, bank equity valuations are stretched (Canadians, Aussie and even some large cap US banks) and do not reflect economic realities. In addition, non-bank players are disrupting the traditional lenders and eating away the already shrinking revenue pie. In Europe, the problem is even more acute given that the banks have multiple fundamental problems including shrinking margins, high cost base and very poor growth prospects.
Fool me on growth, fool me on inflation but GIMME (Guaranteed Indefinite Maximum Monetary Easing) QE forever seems to the only way to keep risk assets from completely falling over. Given that decent global growth levels are getting increasingly difficult to achieve and inflation not reaching targets in any sustained manner, central bank after central bank are outplaying one another on who is going to be more dovish. And the minute there is a semblance of monetary policy normalisation, investors are throwing a big tantrum and running for the hills.
This backdrop means that monetary accommodation is likely to stay for extended periods of time or even indefinitely and that certainly seems to be the case in Europe. In addition to the above issues facing the sector, investors are focussing on:
If you didn’t notice, European Bank Index (SX7E) was down almost 7.5% last week reflecting investors angst and despair about earnings momentum. We can add to it the Brexit related uncertainty and the very poor PMI numbers in Germany and France.
From an equity investor perspective, at first sight, valuations across the sector seem cheap given the low Price/TNAV (trading at a large discount to tangible net asset value), attractive dividend yield and fairly priced on a price to forward-looking earnings estimates. But all of the three valuation metrics could still be questioned – is TNAV accurate? Are dividend payouts sustainable? Are the forward estimates realistic?
Valuations may be cheap and attractive but markets see to be focused on the “unknowns’ and risk/issues outlined above and they are unlikely to be resolved anytime soon. Clearly qualitative factors comfortably taking precedence over quantitative models.
With bank equity looking potentially expensive and likely to underperform, investors may be forced to look into high yielding assets such as AT1s and bank sub debt. Whilst the carry on AT1s may be attractive (given where risk-free assets are trading) there are other issues to consider including risk premium, equity/rates volatility and most importantly secondary market liquidity.
The structural weakness of the European banks come to the fore when they are sliced and diced in a worst case scenario – very poor earnings profile, inadequate reserve coverage for impairments and core capital shortfall due to leverage. In such scenarios (though a low probability event), at least for some banks, capital burn is significant and whilst equity investors will take most of the hit, the AT1 instruments may yet come into play in terms of potential write-downs or conversion into equity.
This I think would be due to the issuer reaching PONV (point of nonviability) and regulator stepping in well before actual triggers come into play. This PONV is the biggest unknown qualitative factor (and one that is decided by the regulator) in AT1 valuation. Thus, single name selection becomes even more important in AT1 investing.
One thing is for sure – this asset class needs specialist / expert handling – someone who understands the macro picture in addition to having a deep knowledge of the issuer and the sector and can handle the volatility that comes from the underlying cross-asset structural features.
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 7% (and above) on a yield to call basis and 6% on a yield to perpetuity basis should find some decent interest. A number of AT1s issued by large cap high quality European banks screen well on this metric including the likes of Lloyds, HSBC, UBS, ING, Nordea.
And when it gets there, I believe specialist bank capital funds, distressed debt investors 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.
Sub debt is always going to trade on the back of equity performance and investor perception and hence unlikely to materially tighten in spread terms but may outperform equity/AT1. In particular, the sub debt issues from the large banks in Italy and Spain are attractive to own.
Also, it appears to me that Non-preferred senior bonds issued by the larger banks and TLAC paper issued by global banks are starting to become attractive as defensive plays to fund shorts in other parts of the capital structure and/or across names.
In conclusion, there are some interesting relative value opportunities in the bank capital space and investing in it is becoming much more interesting from a relative value perspective. To some extent this strategy takes out the directional risk element. Careful single name selection and then determining which part of the capital structure to invest is clearly becoming more crucial.
Some examples include being long AT1s issued by Uncredito and short that bank’s equity. Or taking on a long NPS issued by ING Bank versus shorting ING Bank AT1s. We like being long ACAFP AT1 versus the bank’s LT2. And we would like being long UK and Nordic bank AT1s against SX7E put options. In all cases, the exact choice of issue and the trade notional ratios need to be carefully selected. For more insight and recommendations, drop us a line.
I had set out my Bank Capital Outlook at the beginning of the year (2nd January 2019) wherein I saw significant scope for generating substantial returns (10%+) based on single name selection and evaluation of macro factors. And as of now, this strategy has returned 6% YTD.
Now, following yesterday’s ECB meeting wherein additional accommodation was announced, subtle changes to the investing strategy are required.
ECB’s TLTRO 3 will undoubtedly help the EZ banking system with more liquidity and funding options and will help the weaker banks to roll over existing debt – and also help credit creation in the process. Overall, the probability of default should decrease further as banks fund through the ECB.
Without economic growth, most of the existing NPL stock is unlikely to go away and, in fact, may lead to further NPL creation. In any case, earnings are likely to be impacted due to margin compression and given the high cost base, little room for additional loan loss provisions. And if banks were to take additional litigation/settlement and restructuring costs, earnings are likely to come under pressure.
Return on Equity is already low for many of the banks, and may yet go lower. Given the 10%+ COE for most EZ banks, the case for investing in EZ bank equities is just not there. To me, there is plenty of downside in EZ bank equities.
Whilst the ECB may have solved the liquidity issue, it has not taken away the potential Solvency issue (in case of a deep recession and/or other tail risks) and consequent recapitalisation for some banks and this new TLTRO does not address that. I believe that there is still plenty of downside in EZ bank equities.
Most of the AT1 issued by large cap EZ banks do look attractive. However, one needs to take into account the potential extension risk and especially those AT1s with low reset spreads.
Once the right issuer has been identified, then AT1s issued by that bank would be attractive to own if:
And if rates keep rallying, the chances of non-call actually increase as banks may be incentivised to keep the existing AT1s instead of tapping the markets for replacement.
So, I think the longer call AT1s may be better to own ahead of short-dated calls. Also, it is better to own the national champion peripheral bank AT1s given the additional yield and hedge them with single name equity puts.
My personal view is that the Non-Preferred Senior / Holdco Senior issued by the large EZ banks look very attractive on a risk-adjusted basis (taking into account probability of default and loss given default). The spread differential between NPS and LT2 of the same issuer seems to be excessive. The only issue seems to be the potential large supply of NPS debt, but I think that it has been overplayed.
And in CDS land, I think Senior Fin Index is wide relative to Main and I see Senior Fin trading through Main over the course of the year. And within Single names, Senior CDS of peripheral EZ banks look wide relative to Core EZ banks and expect further compression.
2019 will continue to be a very interesting year for bank capital with loads of opportunities and significant volatility. But there is significant scope for generating substantial returns based on single name selection and dynamic portfolio risk management.