09 Septembre 2016

Recent developments in the banking sector remain credit friendly

The market quietness of the summer weeks should not hide the fact that some important developments have occurred for financial institutions and may well impact the outlook for the sector over the next few quarters. On the topic of financial results for Q2, there was no high-profile bad surprise to scare the market despite Commerzbank profit warning. Most of the largest European banks’ earnings were in line with market estimates as financial discipline and low credit costs helped balance the pressure on revenues and NIM. Importantly, the capital position of most banks continued to improve thanks to stable balance sheets, sustained retained earnings and some asset and/or portfolio disposals. The weak profitability of the sector remains a concern, as low rates, limited asset growth and the stricter regulatory environment create significant challenges. However, this should have a greater negative bearing on stock valuations than on the credit instruments issued by European financial institutions, in our view.

On the regulatory front, there were also some constructive developments for bank credit. Far from creating volatility and risk, the EBA stress tests highlighted the improvement and resilience of the sector’s credit profile in most countries. They also contributed to create some momentum to find some permanent and structural solutions to the weaknesses of the Italian banking sector, a process which seems now on a better track than ever before. Sentiment was also enhanced by the change in management at Italy-based Unicredit and the resulting solvency-boosting actions taken and/or announced, as well as some encouraging announcements related to the rescue of Italy-based MPS – a bank in a quasi-insolvent state. Importantly, it seems that we are getting increasing clarity on various important topics for bank creditors: the subordination of shareholders’ compensation relative to hybrid capital holders, the calculation methodology for the coupon payments of deeply subordinated instruments, the definition and technicalities of loss-absorbing capital ratios, the implementation of leverage ratios, to name a few.

Finally, several institutions called some of their legacy hybrid capital instruments. Although this was not a real surprise to us, this was a welcomed reminder that the loss of the old-style instrument’s regulatory capital content combined with the need for European banks to maintain market access for new hybrid capital going forward offers a strong incentive for banks to behave in an investor-friendly manner. This is another sign that banks continue to be managed in the interest of their creditors, a powerful investment theme which remains very relevant in our portfolio construction at the moment.

Primary markets at full steam: a source of opportunities and of concern

With the steady market environment for European credit and the direct and indirect impacts of the ECB CSPP, the level of activity in European primary markets has been very high before the summer break. The volume of supply across the various market segments – IG, HY, hybrid capital – has kept a similar pace since the end of the summer lull. Importantly, it has been well absorbed by investors so far, as the demand for credit assets remains very solid. Within fixed income allocations, some large portfolio rebalancing is taking place in favor of credit, whereas pension and insurance money is taking more duration and credit risk. With negative deposit and short-term interest rates, portfolio managers also reduce their cash balances – which could create significant market volatility in the event of investor redemption in the future. Last, there has also been steady inflows in credit from retail investors in search for yield and a substitute for cash.

Although we welcome the healthy state of European primary markets in Europe at the moment and we take advantage of certain investment opportunities it offers, we are also looking carefully at the overheating signals it may be sending. Specifically, we note that new issue premia have shrunk considerably while the average maturity has lengthened. In certain market segments, structures and documentation have become more aggressive therefore diminishing investor protection in the event of some potential credit events. Last, we monitor the secondary market performance of the recently-issued HY bonds as a bellwether for future investor risk appetite; although such performance has been rather solid recently, we remain cautious in our positioning as this market has gotten carried away in many occasions in the past.