In the land of the high yielding USD AT1s, a number of issues appear very attractive to own given cash prices and recent sell off. Out of that lot, a couple of issuers stand out given their strong balance sheet, low risk business model and are shielded from most tail risks. One such name is UBS which reduced the reliance from the volatile FICC units to more stable wealth and asset management businesses. The UBS 5 Perp 23 AT1 in USD…..
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However, as mentioned in earlier posts, credit may be an unexpected beneficiary as central banks add lifelines to global markets. Hence the need to be in defensive names which are likely to hold up relatively well through this volatile period of adjustment.
Given above, my idea would be to go long in one of the strongest banks in Europe with solid fundamentals and a diversified balance sheet with good capital, asset quality and liquidity metrics and be short in one of the biggest EM plays with significant headwinds.
In my opinion, the AT1s issued by HSBC are likely to be more defensive than the ones issued by Standard Chartered Bank (STANLN).
Also, in my view, HSBC has a much better risk profile than STANLN in every metric. STANLN is still a restructuring story with significant EM exposure especially in the Middle East and India.
In general, the HSBC USD 6 Perp 27 AT1 bond looks attractive to own at 94 cash price on a yield to call (and even as a true perp) and is a good defensive bond to own. I think being long the HSBC 6 USD Perp 27 at 94 cash price versus short the STANLN 6.5 USD Perp 20 at 100 cash price is one of the better relative value trades out there.
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It is not even a full working week into 2019 and we are seeing large volatility across asset classes – yet some of the themes that are likely to persist throughout the year are already getting confirmed:
This potentially means that the main central banks in the developed countries – Fed, ECB, BOE and BOJ resort to the old playbook of slowing/reversing rate hikes; become more dovish in forward guidance and decrease the speed of balance sheet reduction. And the Chinese central bank may go one step further and add further monetary stimulus to tide over a credit contraction.
Whilst this may help risk markets to bump along, the implication for the European banks is more downbeat as it would impact profitability. Lower loan growth (due to credit impulse slowing down) and margin compression (both due to competition and lack of profitable lending opportunities) may see banks struggling to improve top-line revenue growth. Add to this the high cost base and a potential increase in loan losses, one can see earnings trajectory to reverse or at best stay flat. In this environment, most banks likely to struggle to generate ROE close to COE.
Earnings recession is likely to lead to lower shareholder distributions in the form of dividends and/or buybacks. And this lack of earnings visibility is what has caused equity valuations of the major banks to drop 30% or more in the last 3 to 6 months. And in many cases, they trade at P/TNAV of 0.6 times or lower.
Some of the European banks have leverage issues and may yet need to either restructure their operations or reduce their risk assets. Plus, home bias should see some of them retrench and reduce global footprint and /or get out of non-profitable operations or businesses.
Although the above backdrop is not hugely optimistic, in a perverse way, credit investors may be the biggest beneficiaries, especially given the reluctance of European governments to let banks fail.
Looking at the situation differently:
Barring a full blown deep economic recession and/or unexpected tail risks due to political risks, most of the national champion banks in Europe have more than adequate capital to continue as going concern entities and don’t need re-capitalisation. The other area of market concern in terms of liquidity may get addressed through the renewal of the TLTRO program for another 3 years and hence eliminating the need for primary markets to be open for debt rollover.
Suddenly, this low growth, low inflation, asset de-risking set up is creating a situation where bank credit is starting to become attractive given current spread level. Current yields on many of the LT2s and Holdco Senior paper issued by national champion banks in Core European countries are more than compensating for the tail risks out there. And AT1s issued by the large cap banks getting close to fair value and attractive to buy and hold.
The contrarian view is that AT1s issued by banks that meet the following criteria are very attractive and likely to see significant price appreciation on a 6-9 month view:
Ask yourself this question – would you want to own AT1s issued by systematically important banks (yielding 7% or more) or HY bonds issued by firms in highly cyclical industries and with low visibility/transparency? I believe the answer is the former.
And I repeat my view from my 2019 outlook:
2019 is going to be a very interesting year for bank capital and, clearly, there is significant scope for generating substantial returns based on single name selection and dynamic portfolio risk management.
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It may look so bad, yet there is scope for 10%+ returns through careful single name selection.
Growth slowdown and dis-inflation will lead to ECB staying put on rates and potentially re-introducing QE. Another round of TLTRO funds is likely to be made available to banks as capital markets remain shut. Credit contraction likely to persist as banks further de-risk. Populism means tail risks remain high. And finally banking union and an EU wide bank deposit insurance program unlikely to happen anytime soon and that means more fragmentation. Non-bank financial institutions likely to further disrupt lending business models.
Further margin compression to be expected with funding costs going up. Slowdown in capital market activities leading to further revenue pressure. Cost pressure leading to more restructuring and capacity shrinkage. Compliance, legal and settlement costs across the industry to remain elevated.
All of above means expect further profitability issues for the industry and ROE to come under pressure. Most banks unlikely to meet COE and expect mid to high single-digit ROEs for most banks. Capital distributions in the form of dividends and share buybacks to slow down.
Expect a small deterioration in asset quality this year and future NPL formation depends on how low growth gets in 2019. Further, banks exposed to leveraged loan markets, EM cross-border lending and consumer financing should see a large tick up in credit costs this year.
Capital and funding outlook:
Current regulatory capital ratios are fine across the large cap banks but leverage is still an issue. Pressing need is to meet TLAC and MREL requirements and to that expect significant issuance of Non-Preferred senior and Holdco senior paper. Most of AT! Issuance already done but refinancing for 2020 calls may come by if markets open up. Expect non-call in AT1 and LT2 as banks preserve capital.
…but there is scope for plenty of dispersion and hence single name selection becomes key.
Names that screen well on above criteria: Lloyds, HSBC, UBS, ING, Nordea, Svenska, DnB NOR, Credit Agricole
Names that score fine but will be a continuous focus to market participants – Barclays, SANTAN, BNP, ISPSIM, RBS, STANLN, CS
Names that have issues on one or more topics mentioned above and hence need more scrutiny – DB, UCGIM, SG, DANKSE, BBVA, BPIM, CMZB
AT1 – likely to further underperform but will find clearing levels around 8% yield to perp. It is all about relative value within AT1 with defensive names holding up better than higher beta names.
LT2 – potentially the best part of capital structure to own (depending on name) due to limited issuance and overall yields relative to AT! Or NPS. Better to own operating bank LT2 given potential for spread compression.
NPS / Holdco – likely to underperform from current levels due to ongoing issuance requirements and risk premium required for potential bail-in risks. Holdco Senior is structurally better to own ahead of NPS as it benefits from diversified cash flows from operating subsidiaries
Once the right issuer has been identified, then AT!s issued by that bank would be attractive to own if:
2019 is going to be a very interesting year for bank capital and clearly there is significant scope for generating substantial returns based on single name selection and dynamic portfolio risk management.
As usual, the devil is in the detail and through careful single name and single-issue selection there is scope for 10%+ returns in bank capital space.
A decade back in the land of mega-credit there were three big kings – GE as one of the biggest issuers, which used debt markets as a tool to grow its global reach by offering vendor financing, GS as one of the biggest originators and distributors in the debt capital markets and DB as one of the biggest market makers in the OTC credit products.
And all three entities seem to have lost their way. GE with its leveraged balance sheet has found it difficult to generate decent returns in its core businesses, GS has found that traditional investment banking needs low-cost funding and DB has a huge cost base problem and a bloated and capital-intensive fixed income business. Equity investors in all three entities have endured significant pain with sharp falls in their respective stock prices.
GE’s problems seem to be its huge debt pile and involvement in low/non-profitable businesses. Once a global leader in many industries, it has failed to properly read the big transformational changes in some of its businesses. GE’s stock has been hit hard as equity investors don’t seem to like what they see. On the other hand, credit investors have just started to fret about a potential ratings downgrade to junk, which may mean that traditional investment-grade funds may have to sell their holdings. Given the amount of debt issued by GE it seems that the potential transition from IG to junk may cause significant pain to current investors.
GS wants to diversify away from the traditional investment banking business and wants to add a retail banking franchise. Given the ongoing shrinkage of the industry sales and trading revenues due to regulatory changes, disintermediation by newer players, automation etc, the firm has found it difficult to deliver strong earnings.
And now the firm is dealing with legacy litigation and compliance issues, which may yet see more reputational damage and impact revenue growth. As of now it still seems that these issues are more relevant for equity investors but if headlines continue to be negative, credit investors will be impacted given that the paper is issued out of the Holdco entity. And there is not much sub debt to absorb large-scale unexpected losses.
That brings me to DB and the issues are well known. It has a huge cost base problem and is still heavily reliant in the Fixed Income business, which is capital intensive. Further, the scale and scope of its investment banking business has meant that it has been involved in a variety of issues and each requiring significant management attention and – more importantly – exposed the bank to operational risks and large costs. The wealth management business is the bank’s most profitable area and management have failed to divert the capital resources from the investment bank to this unit.
With a cost-to-income ratio of almost 90% and a RoE of about 2%, the scale of the bank’s earnings problem is clear. Given where the stock trades (close to 0.3 times P/TNAV) and level of share price drop, much of the downside risks seem to have been priced in. Credit investors seem to take comfort from the potential intervention of the authorities given its systemic importance.
If any of above three entities were to run into significant difficulty in the next 6-12 months, the impact on the overall credit markets would be dramatic and hence one of the big tail risks to be monitored and risk managed. This, on top of deteriorating liquidity in secondary markets and a general aversion to risk, which will only further amplify spread widening.
Just as an afterthought, there is plenty of talk of a potential DB/Commerzbank merger to create a German national champion bank. Whilst this may yet happen, in my view, the merger is unlikely to solve the underlying issues. In my personal opinion, a more radical idea may be for GS and DB to consider combining their FICC businesses and address the revenue pie shrinkage issue and overall cost problem. That seems very unlikely though given other considerations.
What is the single most driver of AT1 valuation – equity metrics, duration, spread premia for inherent credit risks, risk premium for the varied options sold to issuer – coupon deferral, non-call, and potential trigger risks for conversion/writedown? Whilst the right answer is a combination of all of the above factors (and hence very difficult for ordinary folks to decipher) the real and more important answer seems to be liquidity risks (i.e. finding a clearing level) in terms of finding new buyers. This is especially true when markets focussed on a particular macro tail risk event (say Italian politics or EM contagion) and/or headline risk on the issuer and above-mentioned valuation metrics are thrown out of the window.
Plus sometimes, the correlation between equity and AT1 breakdowns as different investor bases look at them differently, making it impossible to properly hedge out AT1 price drop risks by shorting equity (in some cases adds to the pain trade as AT1 drops due to lack of buyers and equity jumps on short covering). And trading RV between issuers in AT1 has its own issues as in many cases they are not easily comparable and different issuers have varied valuation factors and RV exposes gross notional risks.
The point being that AT1 was issued to investors in good times as a nice carry trade giving decent yields (relative to risk free assets) but investors failed to appreciate the multi-layered risks in the instrument and more so on liquidity risks in terms of being able to get out (especially in size) when the tide turns.
There is only about EUR 150 billion of issuance to contend with and who knows what will be clearing level on many of these issues if we have a big risk-off event and there is a buyer’s strike. And with limited ability for the market makers to absorb this risk (due to post-financial crisis regulations to carry inventory), my concern is that the overall AT1 market is set for further downside risks (and very limited upside risks) with no where to hide.
Indeed, they will get very attractive when YTP reach 8% and above relative to owning equity. But we are not yet there.