11th February 2019

Relative Value in EUR High yield AT1s | Trade Ideas

Periphery or Core Eurozone AT1..tough to choose..

UCGIM or RBIAV AT1

In general, investors seem to like owning AT1s issued by core Eurozone banks and avoid those issued by peripheral banks, especially the Italians. They are probably right to do so to a large extent given the potential tail risks emerging from Italian politics, for example. But, what if there is a core Eurozone bank that is mostly EM in nature but benefits from its Austrian domicile?

That brings us to our trade idea for this week – Long the UCGIM 6.75 Perp 21 at 98 cash price and short the RBIAV 4.5 Perp 25 at 82 cash price…

Raiffessen Bank International (RBIAV) may be based in Austria but it generates significant revenues in CEE countries and has considerable exposure in CEE land.  RBIAV is Austrian in domicile but with significant EM risks (with more than 60% of its exposure in CEE countries and Russia). On the other hand, Unicredito (UCGIM) may be a large Italian bank but it has considerable business operations in Germany and Austria and hence more core Eurozone than periphery in reality.


Rationale

  • Both the AT1s yield almost 8% on a yield to call basis (in fact, UCGIM yields slightly higher than RBIAV).
  • Just looking at the back ends of the two AT1s, it is clear that the RBIAV AT1 (with a back end of MS+388 bps) is unlikely to be called and hence will have to be valued as a true perpetual instrument. The UCGIM AT1 has a back end of MS+610 bps and hence has a higher chance of getting called.  Valuing RBIAV as a true perp and assuming investors demand an 8% running yield, the AT1 should drop to low 70 cash price area.
  • On the other hand, even assuming that the UCGIM AT1 is not called and assuming the same 8% running yield to perp, the bond should drop to low 90s cash price area.
  • Just as UCGIM needs higher risk premium for tail risks relating to Italian politics, RBIAV needs higher risk premium for significant EM risks. In my view, RBIAV deserves a higher risk premium reflecting its exposures in CEE and Russia and its limited ability to raise additional equity capital in the event of a sharp slow down in EM land. To some extent, I believe that the bank’s COE is around 12% to 13% and hence AT1 needs a higher yield.
  • Fundamentally, UCGIM is a much larger and higher quality bank than RBIAV in every possible way – diversified revenue streams, larger size in terms of both assets and market cap, and is a systematically important Eurozone bank.
  • UCGIM has valuable franchises in Austria and Germany which it could dispose of to raise further capital in the unlikely event of needing additional capital from an Italian crisis.
  • If risk aversion were to hit AT1s in general, RBIAV’s AT1s will materially underperform given its current low coupon, low back end reset (if not called) and history of not calling subordinated debt.
  • The cash price differential between these two AT1s has compressed in recent months due to Italian politics coming to the fore and currently trading around 15-16 points apart. Over time I expect this cash price differential to go back to 23-25 points over the next few months with RBIAV underperforming.
  • The UCGIM AT1 has traded as high as 112 cash price in 2018 and potentially outperform all other periphery AT1s given recent earnings report. With a CET 1 ratio of 12.07% and net income of EUR 3.9 billion for FY 2018, UCGIM is finally starting to deliver on its restructuring efforts and significantly reduced NPL portfolio.
  • UCGIM results were announced on 7 February which showed good operational performance and significant balance sheet strength. With a current MDA buffer of 201 bps and tangible equity of EUR 47 billion, AT1 investors should feel comfortable with both risks (coupon suspension and potential write down from capital adequacy shortfall trigger), which I see as remote for now.

Conclusion

The UCGIM EUR 6.75 Perp 21 is one of the attractive AT1s to own given the yield to call of 8% and back end reset of 610 bps. But it has been impacted by risk aversion to Italian bank AT1s.

Given the current risk on risk off scenario, it may be better to trade this AT1 on a relative value basis and more so against an AT1 issued by a bank with significant EM exposure and has very low reset. That makes this trade relatively attractive given limited downside (as both will drop on weakness) but good upside as UCGIM outperforms over time.


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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.