8th March 2019

ECB’s Third Let’s Try Risk On (TLTRO 3) | Free Content

Post-ECB Meeting

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 keep on accommodating again and again

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.


Equities look slightly vulnerable

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.


AT1 is attractive but needs careful selection

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.

Is AT1 attractive to own?

Once the right issuer has been identified, then AT1s issued by that bank would be attractive to own if:

  • 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

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.


NPS the sweet spot

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.

CDS land..

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.


Conclusion

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.

GJ Prasad

A senior European bank research specialist with significant breadth/in-depth sector knowledge, GJ has researched bank capital instruments extensively - having covered the asset class for more than 15 years as an analyst and 7 years as a risk taker in buy-side roles. His specialisation includes carrying out detailed financial modelling work on the European banks focusing on asset quality, earnings and capital adequacy metrics. His deep-dive work focuses on single name selection and extensive risk analysis on capital securities, especially on structural features, issuer credit profile and equity/AT1 valuation.