Category Archives for "Bank Capital"

18th January 2019

You want yield but from “Almost safe bank”? | Bank Capital Insights

What yields 8.5% YTC and 6% YTP and is issued by the “most defensive” European bank?

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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15th January 2019

Steady, Stable, Sound – thus far | Bank Capital Insights

Decent start to US bank earnings We had three large US banks (Citi, JPM, Wells Fargo) report Q4 2018 earnings and there were similar attributes in terms of earnings, outlook and similar comments on the state of the US economy.   All three reported sound increases in year-on-year earnings though they fell short in terms of […]
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13th January 2019

Now comes the hard part | Bank Capital Insights

Will forthcoming bank earnings help or hinder risk sentiment? Last week was a good one for risk assets especially in bank capital (and within that AT1) driven by dovish Fed speak, trade war resolution optimism and no new “unknowns” to rattle investors.  Add to that the lack of supply in high yielding paper in bank […]
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9th January 2019

Food for Thought Idea in USD AT1 Land | Bank Capital

HSBC 6% Perp 27 AT1 looks very attractive relative to STANLN 6.5 Perp 20 AT1

Macro background:

  • USD swap rates continue to widen especially in the front end and we continue to see the curve flattening
  • Global growth is slowing down but with potential sticky inflation (oil/commodities driven). Trade wars, protectionism and increasing geopolitical risks are going to create volatile moves in markets
  • EM currency and hard currency debt is coming into focus given the record level of issuance in recent years
  • Repricing risks in new issues and new issue markets being shut
  • Potential end of global easing and accommodation
  • Diminishing appetite for risky assets

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.


Rationale:

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.

  • HSBC AT1 is IG rated at 2 agencies (Baa3/BBB-) while STANLN AT1 is sub IG at the 3 agencies (Ba1 / BB-/ BB+)
  • HSBC USD supply over given recent jumbo $4 billion issuance. STANLN has to issue AT1 and/or refinance existing AT1 and that too in USD (given balance sheet is USD)
  • HSBC 6 has traded 2-3 points higher than STANLN in the past 12-18 months and is now trading 5 points lower. Expect relationship to normalise back to unchanged or STANLN to trade lower than HSBC.  Upside in trade is about 4-5 points with limited downside risk of 1 point
  • HSBC equity has vastly outperformed STANLN over the last 12 months and is likely to do so going forward
  • Valuation-wise – HSBC 6 AT1 trades wider than STANLN 6.5 AT1 purely due to duration risks and the perception that STANLN will call the 2020 bond. But given that a new AT1 would cost the bank the same as the existing one, they may not call (STANLN call their sub debt bonds purely on economic basis and they have not called legacy Tier1s)
  • STANLN COE should be around 11% (so theoretically AT1 yield should be around 8.5% yield adjusted for tax benefit) while HSBC COE is potentially around 9% (and theoretically AT1 yield should be 6.5%)
  • In both cases, coupon suspension and conversion triggers are remote and subject to the same UK regulations HSBC dividend yield is almost 6% and STANLN is 2% with potential for dividend to be suspended again
  • Both bonds are highly liquid (HSBC 3 billion issue and STANLN is 2 billion issue)
  • HSBC reset on non-call is 5-year swaps + 3.746% and STANLN reset is 5-year swaps +4.89%.  A new STANLN 5/7 year USD Perp AT1 would price around 7.75% (MS + 500) and that too if market conditions are favourable and investors want EM exposure
  • There is a general perception that there are plenty of PB investors in STANLN 6.5 AT1

Conclusion

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.

PS – for detailed rationale and data analysis to support the above idea please reach out to us to discuss.


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7th January 2019

The Contrarian View in Bank Capital Investing | Bank Capital

Poor equity – Same old pain…

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:

  • Global growth slowdown, especially in China and Europe;
  • Disinflation or inflation staying well below target;
  • Tightening financial conditions and slower credit creation;
  • Strained liquidity conditions;
  • Large and sudden bouts of market volatility; and
  • Populist measures getting traction

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.


Credit may yet become an unintended beneficiary

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:

  • Lower loan growth and/or asset de-leveraging may lead to higher capital ratios and better solvency metrics;
  • Ample central bank accommodation and alternative funding arrangements may result in limited issuance in capital markets;
  • Poor or low dividend yield results in investors chasing higher yields in sub-debt; and
  • Coupon suspension risk is eliminated as capital buffers improve

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.


Conclusion

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:

  • Yield to Perp is close to 80% of the bank’s COE;
  • AT1 yield is double the bank’s dividend yield;
  • No more issuance to meet regulatory capital thresholds;
  • Significant headroom on both coupon paying ability test and conversion trigger test;
  • The bank’s equity is trading at or above 0.6 P/TNAV;
  • Issue level rating likely to move to IG at all 3 agencies

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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2nd January 2019

European Banks – 2019 Outlook | Bank Capital

It may look so bad, yet there is scope for 10%+ returns through careful single name selection.

General macro outlook

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.


Earnings Outlook

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.


Asset Quality Outlook

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.


What does the sector need for us to get excited?

  • Interest rate regime to normalise
  • Regulatory regime to stabilise
  • Merger activity and/or capacity shrinkage
  • Significant cost base reduction
  • Banking and capital markets union
  • Political risk premium to subside

…but there is scope for plenty of dispersion and hence single name selection becomes key.

Winners are likely to be those firms with:

  • A transparent and relatively straightforward business model
  • Strong customer franchise especially in retail banking and able to defend interest margins
  • Low cost to income ratio
  • Solid asset quality with high reserve coverage
  • Good RWA/Leverage ratio density
  • Solid equity capitalisation

Whom to own and whom to avoid/dodge?

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

The outlook for bank capital instruments:

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

When is AT1 attractive to own?

Once the right issuer has been identified, then AT!s issued by that bank would be attractive to own if:

  • Yield to Perp is close to 80% of bank’s COE
  • AT1 yield is double the bank’s dividend yield
  • No more issuance to meet regulatory capital thresholds
  • Significant headroom on both coupon paying ability test and conversion trigger test
  • Bank’s equity is trading at or above 0.6 P/TNAV
  • Issue level rating likely to move to IG at all 3 agencies.

Conclusion

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.

Get in touch if you need any further clarification on information here or if you want to discuss the above outlook and/or on single names:

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18th December 2018

Three (erstwhile) Kings in credit land | Bank Capital

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 – leverage is always a problem

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 – Old issues not going away

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.


DB – can it really transform in current form

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.


Conclusion

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.

13th December 2018

What drives AT1 valuation? | Bank Capital Insights

Thoughts and observations on an asset class which has peculiar features

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.


Breakdown in correlation

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.


Conclusion

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.

10th December 2018

What now for DB credit? Bank Capital

Negative headlines keep on coming…

Headline risk continues to overwhelm DB stock and, over the last few weeks, it has been hit by a plethora of negative news including its involvement in the Danske Bank’s money laundering case, ongoing tax raids by German authorities, cum-dividend issues on ADRs etc. The impact of these relentless negative headlines has had a significant impact on the bank’s stock, which is now trading at less than 0.30 times P/TNAV.

This raises the question – Can the bank afford to absorb large sized settlement and litigation costs that may yet arise from the above issues?   Given the very high cost base (cost to income ratio is 90%), the bank generates very poor operating income to absorb unexpected losses and if revenues were to decline further due to a lack of client activity and ongoing risk aversion, it exposes the bank to negative earnings and hence a potential hit to equity.   The unknown factor in terms of future litigation costs is a key driver of investor pessimism.   In addition, if the bank were to undertake a very large business restructuring this would involve significant one-off costs, which again adds to the pressure on profitability and ultimately capital build.


Capital ratios are the not the issue, leverage is

DB reports good regulatory capital ratios, well above minimum thresholds – but a 4% leverage ratio for a bank with EUR 1,305 billion of leverage exposure is just not good enough, especially if underlying earnings momentum is weak or even negative. For example, in a highly hypothetical situation, if the bank had to take, say, an additional EUR 10 billion of provisions/costs for the matters discussed above, it would create an almost EUR 8 billion capital hit (assuming current revenues hold) and that would translate to the Tier1 capital dropping to EUR 44.5 billion and leverage ratio falling to 3.4%.  Add to this the EUR 23 billion of Level 3 assets and one gets the picture.   And that is why equity investors are nervous.

Yes, the bank has good liquidity buffers and can withstand potential short-term counterparty/deposit flight. But the wall of debt that is maturing over the next few years (almost EUR 20 billion every year until 2022) means that the bank is reliant on wholesale markets being open and available.


Can a merger with Commerzbank make a difference

Press reports over the weekend indicate that the German Government may be considering a merger of Deutsche Bank with Commerzbank to create a large German national champion bank. At first glance, this looks an interesting option to combine two underperforming banks with similar attributes in terms of low profitability and limited future visibility but with significant scope for cost reductions and a larger capital pool to absorb losses.

But merely creating a much larger entity does not solve the underlying core issues faced by both banks, more so for DB; The reason being that the bank is too large and too complex to be managed as a standalone entity and any additional merger will only complicate matters and cause further uncertainty.

DB’s issues stem from multiple factors – oversized/overstaffed businesses in FICC land and a strategic failure in the past to redirect capital to the more profitable wealth management and corporate banking businesses.  FICC is a highly cyclical business and one that is undergoing profound structural change. Technology and automation are the key drivers of profitability in that business and DB has been very slow to react and adapt to the new landscape.  What DB needs is a radical restructuring in the FICC business and it needs to get rid of many units that are currently generating very poor returns – and downsize its balance sheet exposures significantly.


Equity looking down the barrel but credit hoping for better times

Equity investors have taken notice of the issues and hence give the poor valuation on its stock. It seems that credit investors especially AT1 and LT2 investors are stuck in no man’s land and unsure of what to do next (yes, the yields are attractive but there are significant tail risks).

In my personal opinion, the bank’s AT1s are still not fully reflecting the substantial downside risks especially in the unlikely event of PONV (point of no viability) being reached or if there is a significant counterparty run. Coupons may not be at risk for now but it is still an overhang given the low profitability and current levels of ADI.


Can CBK save DB credit investors?

CBK as in Central Bank Kindness and not Commerzbank.

Given the systemic nature of the bank in the global financial system, it is likely that some form of government or central bank support (at least in liquidity) would come through but that will be at a price wherein sub-debt holders will be fully bailed in.

To that extent it seems to me that only the preferred senior part of the capital structure is safe for now (though one may yet get spread widening). I fear that credit investors have still not fully factored the potential downside risks.

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