- by GJ Prasad
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.
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.
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: