By Steve Hussey, Jørgen Kjærsgaard
For shareholders of European banks, 2020 was a year to forget. But bank bondholders have enjoyed positive returns and could weather the challenges of COVID-19 again in 2021, supported by strong balance sheets and supportive regulatory conditions.
The impact of the coronavirus has increased the pressure on the capital of European banks. Already struggling with weak growth and low interest rates, COVID-19 has triggered new loan loss provisions, weaker earnings and constraints on dividends. Yet some of these factors have improved the position of bank bondholders, for several reasons.
Balance sheets strengthen as 2021 approaches
Most banks enter 2021 in a relatively strong position. In 2020, they have generally been able to strengthen already strong balance sheets in two ways.
First, restrictions on dividend payments and share buybacks in 2020 by the European Central Bank (ECB) and the Bank of England (BoE) have prevented banks from distributing capital. Although dividend payouts are permitted in 2021, they will likely be capped at a small percentage of earnings.
Second, regulators have given banks considerable leeway to continue lending to businesses without incurring regulatory interventions. This “regulatory forbearance” helps banks grow their assets without incurring a penalty through higher capital requirements.
Bank liquidity is also relatively high (Display, below). During the crisis, customers spent less and saved more. The ECB also contributed to cheap funding, extending its targeted longer-term refinancing operations (TLTROs) aimed at supporting the eurozone economy. And outside of government-backed loans, loan growth has generally lagged deposit growth, so excess deposits have been recycled into liquid assets.
Asset quality can fall, but from a high level
Many companies in the euro zone are still facing a difficult year. The main risk is that they will struggle to service their debt if government and central bank support ends in 2021. In this scenario, unemployment would likely rise and default rates would rise for small and medium-sized enterprises. medium-sized businesses, especially in hard-hit sectors like hospitality, tourism and retail. Going forward, the banking sector would be negatively affected by a deterioration in payment defaults.
But even if this erodes the quality of banks’ loan portfolios, their starting point is solid. Non-Performing Loans (NPLs) are at historically low levels and provisions for potential losses have been increased. Crucially for investors in banks’ additional tier 1 (AT1) contingent convertible debt (CoCos), our research suggests that most banks now have enough capital to absorb potential losses – well above the levels provisioning – without triggering equity conversion or amortization. .
Low profits are a problem, but especially for shareholders
The past five years have been a nightmare for European bank shareholders. Tighter global regulation has forced lenders to raise capital while a low growth and low interest rate environment has reduced earnings and return on equity. The year 2020 and the coronavirus crowned a dark period (Display, below).
In effect, value has shifted from shareholders to bondholders, whose principal and interest payments are better protected as regulatory measures have strengthened balance sheets.
Even so, bank profits are also important for bondholders. And fortunately, profitability is not a lost cause. COVID-19 has accelerated banks’ efforts to upgrade systems, digitize operations, and improve efficiency and profitability. At the same time, the ECB is supporting merger and acquisition activity which should help reduce costs and create a more consolidated and stronger banking sector. Thus, for bondholders, earnings should still be sufficient to prevent capital erosion that would threaten their investments.
AT1 ratings are always compelling
Despite a strong rally in 2020, we believe AT1 valuations remain attractive, both in absolute terms and relative to comparable asset classes (Display, bottom left).
AT1s offer wider spreads than other similarly rated fixed income investments at each point on the credit quality spectrum, from BBB to B. And within financial credit, the spreads between AT1 debt and BBB debt level 2 widened from an all-time high of 146 basis points (bps) in February 2020 to 261 bps by the end of 2020. This leaves plenty of room for spread compression as the virus recedes and markets normalize, in our view.
Additionally, AT1s have also shown better risk/return characteristics than bank stocks during both bull and bear markets (Display top right). The high and predictable coupon on AT1s (currently 6.1% on average) has been much more favorable than bank stock dividends. And AT1 prices are more influenced by the capital strength of banks, which have improved, while equities are heavily biased towards less reliable earnings.
Bank capital remains key to eurozone recovery
In our view, the trends that have supported AT1s in recent years are likely to persist throughout the rally. Regulators are keen to ensure that the banking sector has sufficient capital to support lending to eurozone businesses and support economic recovery. Countercyclical buffer requirements should also remain low to help free up bank capital, promote lending, and lower the minimum capital banks must hold to pay the AT1 interest coupon. This requirement reduces the risk of missed payments (coupon skip) for investors.
Regulators also want to give banks more time to comply with the new, more onerous capital requirements (TLAC/MREL), thereby reducing the pressure to issue senior or subordinated bonds. As a result, we expect AT1 net supply to remain low as most banks already meet current minimum regulatory standards. In the meantime, we think high AT1 yields are likely to attract growing demand as the virus recedes and economies rebound.
Be selective in AT1s
The AT1 market has rallied from the March 2020 lows and valuations for some bonds may be less attractive, especially since the volatility of these securities can be quite high, as was the case in 2020. depth can identify names that offer compelling risk/return characteristics and pockets of unrecognized value. For example, some smaller banks may be merger or acquisition targets and could see their spreads compress in line with the obligations of the stronger acquiring banks. Some Spanish and Italian banks still offer good value, in our view, as do older Tier 1 issues, which should be called now that regulations have been clarified.
Bank bonds have benefited from a powerful tide during the pandemic. While many of the support trends are still advancing, bondholders should remain confident in European banks.
The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the views of all of AB’s portfolio management teams and are subject to revision over time. AllianceBernstein Limited is authorized and regulated by the Financial Conduct Authority in the UK.
Past performance is not indicative of future results.
This article is not intended as investment advice. Readers should ensure that they obtain appropriate advice from their financial advisor before making an investment.
The value of an investment can go down as well as up and investors may not get back the full amount invested.
Contingent Convertibles (CoCos) are a more complex type of bond that converts into equity if a pre-specified trigger event occurs. The risk of investing in these types of instruments is that holders of CoCos will experience losses before other equity investors and may not receive the return on their investment. AT1s are a subset of CoCos.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.